Boost counters Fed criticism of leveraged and inverse ETFs

Aug 28th, 2013 | By | Category: Alternatives / Multi-Asset

Boost, an independent provider of exchange-traded products, has countered criticism of leveraged and inverse (also known as ‘short’) exchange-traded funds (ETFs) from the US Federal Reserve (Fed).

Boost ETP counters Fed criticism of leveraged and inverse ETFs

A recent report by the US Federal Reserve suggested that leveraged and inverse ETFs could trigger a “cascade” reaction.

In a statement, the London-based firm, which specialises in leveraged and inverse products, said there was need for “more clarity and reasoned debate around the conclusions” of a recent Fed report entitled Are Leveraged and Inverse ETFs the New Portfolio Insurers?

The report, authored by Dr Tugkan Tuzun, an economist and one of the Fed’s governors, essentially concludes that the need to maintain constant stock-to-cash ratios forces leveraged and inverse ETFs to rebalance in the same direction as their underlying indices, selling in a declining market and buying in a rising market. The price impact of this becomes significant during periods of high volatility – especially for financial firms – and could amplify market moves, ultimately forcing these products to further rebalance. This, in turn, could trigger a “cascade” reaction leading to disproportionate price changes and large investor outflows.

Boost feels that the view taken and the conclusions reached by Tuzun are simplistic in approach and ignore the basics of how markets work and the facts related to leveraged and inverse ETFs, adding that the report’s title is “clearly designed to grab attention”.

Commenting, Hector McNeil, Co-CEO of Boost, said: “We think the Tuzun paper is a headline grabber and doesn’t stand up to real world scrutiny. Given the size of the short and leveraged ETF market globally and the strategies that investors employ when using them, we firmly believe the impact is minimal. Short and leveraged ETFs provide an important tool for investors to hedge their portfolios and protect their investment as well as an efficient way to gain exposure to a market and preserve valuable capital.”

He added: “When compared to other ways of gaining leverage or short exposure, such as futures, options, CFDs, spread bets and structured products, short and leveraged ETFs have some real benefits. Investors can’t lose more than their initial investment; they don’t need to complete complex derivative documentation; they trade on exchange with multiple market makers; and counterparty risk is managed through a robust and transparent collateral processes.”

Boost proffers four main arguments in defence of leveraged and inverse ETFs. They are as follows:

First, leveraged and inverse ETFs are market access tools and do not invent trading, but rather give investors tools to use to express their views and achieve their investment objectives. Moreover, leveraged and inverse ETPs sit alongside numerous types of leveraged trading vehicles, such as prime brokerage accounts, futures, options, structured products, margin trading, OTC derivatives, CFDs, spread betting, etc, many of which employ significantly greater leverage than the standard two or three-times leverage offered by short and leveraged ETFs.

Second, global assets invested in leveraged and inverse ETFs is around $50 billion. This is inconsequential compared to the $2 trillion of assets under management (AUM) in global ETFs, which itself is less than 10% of global AUM in mutual funds. This is further diluted by the fact that leveraged and inverse ETFs tend to only give access to the most liquid underlying markets.

Third, stock markets already tend to see the majority of trading activity at the start and end of the day in a U-curve shape. These are precisely the points of the day when liquidity is highest and where leveraged ETF rebalancing is least likely to have an impact.

Fourth, very often investors use leveraged and inverse ETFs in order to hedge their existing positions. Therefore, the likelihood is that if leveraged and inverse ETFs were not available these investors would be forced to employ more capital in essentially the same way as leveraged and inverse ETFs do or liquidate positions short term in sharp market movements, which could in itself contribute to a “cascade” effect.

In addition, Boost suggests that historical research conducted by other academics is at odds with the Fed report’s conclusions. The firm cites research from William J. Trainor Jr (2010), concluding that leveraged ETFs do not appear to have any substantial effect on the market, and from Credit Suisse (2011), concluding that “leveraged ETF rebalancing trades are unlikely to be the most influential factor in driving intraday swings into the close”.  And while this research predates the Fed report, Boost says that there have been no significant changes to the AUM or structure of leveraged and inverse ETFs which would have altered these earlier conclusions.

Boost is the first of the leveraged and inverse ETF providers to publicly challenge the Fed’s latest findings. Other major providers in the space include ProShares, Direxion and VelocityShares, all US based, and Lyxor/Societe Generale, ETF Securities and db X-trackers in Europe.

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