The debate over the effects of leveraged ETFs is heating up again, this time in Japan, where another market whale is making waves. As Bloomberg reports, some are blaming increased volatility in the final moments of trading on the Tokyo Stock Exchange on the world’s biggest leveraged ETF: the Next Funds Nikkei 225 Leveraged Index ETF run by Nomura Asset Management. Assets in the ETF have more than doubled over the last five years Bloomberg reports— it’s now a US$6.5-billion ETF behemoth that’s being accused of amplifying moves in Japan’s stock market. The evidence? Over the last two months, Nikkei 225 Stock Average has compounded its intraday return in the final 15 minutes of the trading day 70% of the time. Since leveraged ETFs need to buy or sell at the end of the trading day, depending on whether shares rise or fall in value, that pattern would seem to match the trading needs of the Next Funds ETF.
But pinning increased volatility on leveraged ETFs has been difficult to do as a flurry of research papers written over the last few years has shown.
You could say the finger-pointing at leveraged ETFs started in 2010, when New York Times writer Andrew Ross Sorkin concluded that leveraged ETFs are the probable cause of extreme market volatility during the last minutes of every trading day. Soon after, the U.S. Securities and Exchange Commission issued a moratorium on approvals for any requests for new inverse or leveraged ETFs.
Then last fall, two researchers from the Board of Governors at the Federal Reserve System addressed critics of leveraged ETFs and concluded that concerns over their impact on market volatility was likely overblown. Why? Because it ignores the effects of capital flows on ETF rebalancing demand—money coming in and out affects the amount of additional leverage the ETF requires to maintain its target leverage ratio. You can read that paper here.
More recently, I wrote about another research paper that does find evidence of increased volatility as a result of leveraged ETFs. This paper, which looks like real estate ETFs, finds that leveraged ETF-related trading caused “prices overshooting and volatility” late in the day (between 3 p.m. and 4 p.m.) for smaller, volatile real estate sector stocks. That overshooting tends to be reversed in the first house of the next day.
On days that real estate sector volatility is high, the size of the impact on a typical stock during that 3 p.m. to 4 p.m. time can be 234 basis points and can swing as high as 327 basis points.
For its part, Nomura points to the capital flows argument to explain why the mega ETF isn’t a problem – since its investors are contrarians for the most part, capital flows in and out tend to reduce the size of trades.
Still, for every one percent move up or down in the Japanese stock market, leveraged and inverse funds have to buy or sell $285 billion near the close reports Bloomberg. And a group of speculators following the ETF’s activity aren’t making the situation better.
Nomura has halted subscription orders for its ETF citing inadequate liquidity in Japanese index futures for its decision.
In the meantime, the role of leveraged ETFs will likely continue in markets gripped like Japan’s, which has been gripped by volatility and is attracting increased speculation. Which means researchers and policymakers must continue to look under the hood of leveraged ETFs and work to isolate their true impact on capital markets.