Leveraged, inverse and inverse leveraged exchange-traded products first came on the scene in 2006. During the financial crisis, however, they rose to prominence as they showed outrageous returns. Many were attracted to the price swings and the opportunity to get amazing returns in a short period of time. Since that period, according to Michael Sapir, “the understanding in the market for these products has matured significantly.”
And a new report offers even more maturity and insight. A working paper titled “Are Concerns About Leveraged ETFs Overblown? was recently written by Ivan T. Ivanov of the Federal Reserve Board and Stephen L. Lenkey, an assistant professor of finance at Penn State University’s Smeal College of Business. They have concluded that the money going in and out of the funds, called capital flows, “diminish the potential for leveraged and inverse ETFs to exacerbate volatility.” Dr. Lenkey goes as far as to say, “ETFs with higher leverage ratios tend to experience larger and more frequent capital flows.”
The conclusion the paper comes to is that the overall effect on the market and the underlying index and stocks is actually quite limited, even if an investor can feel that things are unpredictable. They counter the idea that Leveraged ETFs and inverse funds lead to higher gains on up days and larger losses on down days.
As Mr. Sapir explained, “Geared funds were not designed for everyday investors. But institutions and financial professionals can use them to enhance return and manage risk.”
As the researchers concluded in their white paper, “the empirical analysis, we show that liquidity improvement strongly predicts future ETF net inflows, particularly in the price impact and the turnover dimensions. Other indirect proxies for liquidity also enter significantly: tracking error (negative), activity of share creation/redemption process (positive) and expense ratios (negative). We also show that institutional ownership is positively associated with liquidity improvement. Moreover, when we decompose total ETF inflows into institutional and retail inflows, we find that liquidity improvement matters for both groups, but price impact and turnover are much more important for institutional than retail flows. Further, when we classify institutional investors by legal type (investment horizon), we find that liquidity improvement matters much more for investment companies (short-term investors) than for banks (long-term investors). Finally we analyze the importance of ETF and underlying portfolio liquidity on mispricing. As expected, both components have a significant and negative relation with mispricing.”
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