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Fed is Worried About Leveraged ETFs

Leveraged ETFs do not lack for critics. Count the Federal Reserve among those warning investors about the risks associated with these volatile, yet still popular funds.

In a report published last month, Fed researcher Tugkan Tuzun said a “1% increase in broad stock-market indexes induces leveraged ETFs to originate rebalancing flows equivalent of $1.04 billion worth of stock. Price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks.”

Despite the well-documented risks associated with leveraged ETFs, the funds remain popular with investors. Global inverse and leveraged ETFs saw their AUM total rise $1.7 billion, or 3.5%, to $50.9 billion at the end of June, according to Boost ETP. Boost is a boutique firm specializing in trading triple-leveraged ETFs listed in Europe. [Global Leveraged ETFs Flirth With $51B in AUM]

Leveraged ETFs have been one of the most discussed and most criticized sub-segments of the ETF universe in recent years. In addition to the obvious volatility that comes along with double- and triple-leveraged products, these ETFs have been known to deviate wildly from the indexes they are designed to track, leaving investors that held these funds for long time frames holding a bag of disappointing returns. [Investors Still Like Leveraged ETFs]

Those are the known risks, though it should be mentioned that issuers such as ProShares and Direxion do go to great lengths to warn investors that leveraged ETFs are best treated as short-term instruments. That did not stop Tuzun from offering up this ominous comparison:

“Generating multiples of daily index returns gives rise to two important characteristics of LETFs that are similar to the portfolio insurance strategies that are thought to have contibuted to the stock market crash of October 19, 1987 (Brady Report, 1988). (1) LETFs rebalance their portfolios daily by trading in the same direction as the changes in the underlying index, buying when the index increases and selling when the indexdecreases. (2) This rebalancing requirement of LETFs is predictable and may attract anticipatory trading. Portfolio insurance strategies were commonly used by asset managers in the 1980s and their use reportedly declined after the stock market crash of 1987.”

Hopefully, another flash crash or 1987-style market slide does not materialize, but Tuzun does note leveraged ETFs tracking financial services names and small-caps can see amplified volatility during periods of increased market stress. Popular leveraged ETFs tracking those groups include the ProShares UltraShort Financials (SKF) and the Direxion Daily Small Cap Bear 3X Shares (TZA).

Direxion Daily Small Cap Bear 3X Shares

ETF Trends editorial team contributed to this post.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.