ETFS Could Impact The Stock Market Crash.
Some speculate about a stock market crash. The Federal Reserve, on account of a research paper released by the Central Bank entitled, “Are Leveraged and Inverse ETFs the New Portfolio Insurers?” exhorted that leverage exchange-traded funds (LETFs) could cause the next big market collapse. The paper stirred investors into thinking of what could happen if the LETFs today act in the same manner as the portfolio insurance instruments that sent the markets to crash in 1987.
Economist with the Fed’s Board of Governors, Tugkan Tuzon wrote, “Although the LETF’s stake in the financial markets are not comparable in size to the large portfolio insurers of the 1980’s, its concentrated modes of trading could destabilize the highly volatile markets.” The main problem is in the nature of how LETFs work. They provide investors, whether bullish or bearish, two to three times of the market’s outcomes per session, then gets rebalance at the end of each day’s trading . It is the daily rebalancing that is causing much apprehension.
To illustrate LETF’s rebalancing, assuming that you have an average LETF portfolio composed of 60 percent diversified stocks and 40 percent of bonds or debentures, at the start of the day. But it turned up to be a banner day for small cap stock, so at the end of the day, the portfolio will look different – 69 percent of diversified stocks and 31 percent of the bonds. What you do next is bring it back into balance starting with the bonds. You need to bring back the bond balance to 40% by buying additional nine percent (9%). To fund the purchase, you may need to sell stocks equivalent to nine percent (9%) too. However, when you do that – you have to pay capital gains and commission on the ETF trade. So the next possible option, is for you to shore up your losing position by either putting up additional investments, or by using dividends and interests that are earned on your portfolio.
On leverage exposure, a leveraged fund would mean that the ETF uses debt to amplify the movements of an index. These funds use a constant percentage of leverage either – 2:1 or 3:1 at a given time period. If the index earned one percent (1%) for a specific day, the fund will return two percent (2%). However, if the index drops one percent (1%), you lose two percent (2%). Additional transaction and management fees will be added and charged to you, thereby devaluing earnings from the use of leverage. Tuzon further explained the implication of the used of LETFs, “In volatile markets, the implied price impact of LETF’s becomes significant. The rebalancing of LETFs in large moves could amplify the move; hence, push them further to rebalance.
When this happens, a cascading reaction may happen, resulting to stoppage and price dislocation that is akin to a prolonged circuit breaker during a market close. Rebalancing will cause execution of orders within a short time frame, near the end of the trading hour – which could result to disparities in price. A drastic price change may have a negative impact on investor confidence. If the market closes at highly reduced prices, the market are bound to lose investors fast. While it sounds like a fairly scary prospect, not everyone is as alarmed . Some quarters in the industry even finds it highly ludicrous. Gents With No Cents author, Ron de Legge came up with a rejoinder entitled, “35 Questions to the Fed about Leveraged and Short ETFs.” He asked, “How can the Fed lecture about the dangers of leverage when the agency itself is over leveraged?”
On the other hand, the chief market strategist of ConvergEx, Nicholas Colas, finds the Fed concern fairly comforting. In a letter to his clients, Colas said, “ The financial crisis brought about extraordinary regulations by the Fed – bans of short sale of select stocks to calm down the volatile markets. If the Fed calls LETFs as products that exacerbates the downward movement of the market, then curtailing its use during extraordinary situations would come in highly recommended. Nevertheless, the market now has low volatility – per CBOE Volatility Index , which remained at mid range levels despite some turbulence. This probably indicates that the concern over LETFs is premature.” The fund in question amounts $3.3 billion of the $177 billion in new money, out of the $1.53 trillion total. But it is particularly worthwhile to note that these funds earned 44 percent lesser this year.
“There have been long debates in the regulated community about how much the small investors understand LETFs. But my understanding of the cash flow data, shows that they understand it quite well. These products have a specific purpose and you got penalized if you do not attend to it closely. There are caveats on these products that clearly says 'holder beware’. One day really means one trading day. The Fed’s warning is one of those caveats in a market with rising volatility and probable dislocations. When the situation happens, it is good sense to suspend or curtail trading in such funds. Recapping, we cannot help but think that the Fed is fighting yesterday’s battle of a forty handle vix that seemed so faraway.” Cola finally added. This can have a impact on the stock market crash.