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Are ETFs Creating a Spike in Market Volatility?

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Over the past 3 months, the CBOE Volatility Index (VIX) has more than doubled, going from 17 to its current level hovering around 40 today. This is a clear indication that the broader stock markets have been a full of nervous energy and trading, making 2% market swing seem modest.

While investors can point to any number of fundamental, economic or political developments as the catalysts for the mania, some have argued the sheer growth of exchange traded funds or "ETFs" are creating the higher volatility level. In particular, the Wall Street Journal reports that the Securities and Exchange Commission is looking into leveraged ETFs - which enable investors to take long and short positions and can offer 2 to 3 times the amount of exposure to a specific index.

"Leverage and inverse ETF's represent only 4 to 5% of overall trading volume in the market," says Tom Lydon, president resident of Global Trends Investments. He says once you "peel back the onion," you see a totally different situation.

For starters, Lydon says a big chunk of leveraged ETFs are focused on fixed income positions. "So you've got a lot of money that's moving into leveraged Treasury ETFs, so if you take those off the table and balance out the longs and the shorts - which tend to be, on any given day, pretty well balanced - you find out that the overall net volume that's rebalanced everyday in these products is minimal at best," explains Lydon.

Lydon cites recent analysis by Credit Suisse and Morningstar showing "leveraged ETFs had no real impact on overall volatility," adding that "you've got to look other places" if you want to find a suspect. "Look at futures, no one is looking at the futures market and futures volume has been through the roof."

Lydon says the real problem is that investors are just plain nervous and lack confidence these. As a result, risk tolerance is way down and group think is way up. Breakout guest Paul Hickey of Bespoke Investment Group recently referred to this as "All or None Days," when 80% or more of the S&P 500 moves in the same direction.

Furthermore, Lydon says ETFs themselves are approved and regulated by the SEC, which "consistently looks at the trading volume, they're checking with the exchanges, they're checking with the brokers, they're checking with the product providers" for any signs of irregularity or manipulation.

Certainly, ETFs have experienced explosive growth over the past 5 years having gone from relative obscurity to accounting for 40% of the daily trading volume. They are clearly a new target, as well as a large one. Even so, Lydon insists "these products do exactly what they are supposed to do, every day" and are simply reflecting market sentiment rather then creating it.

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