From THOMPSON REUTERS
The Tail Wagging the Dog
We think it is time to address what we consider to be a major contributor to the general distress and uneasiness that plagues our markets today. In the last few months there has been a proliferation of Exchange Traded Funds (ETFs) whose daily movements correspond to twice or more of the inverse of the index they reflect. One leveraged ETF vehicle is at 3x today and we?ve heard rumors that there are instruments on the immediate horizon which will even further increase the leverage up to 10x ETF. Some of these leveraged securities reflect broad macro indices which, while troublesome, are not as horrifically negative as those which reflect particular subsections of the market, e.g., Financials, Real Estate Investment Trusts, and various commodities, to name only a few.
Leveraged long and short ETFs are making an already unstable environment much, much worse and are removing whatever faith in our public markets remains. In addition, they are making otherwise stable individual securities, for example, Simon Property Group (SPG) and Equity Residential (EQR), to name only two of hundreds, both of which are reflected in the ProShares Ultra Real Estate long (URE) and short
(SRS) ETFs, causing them to look and behave like volatile growth stocks such as GOOG and AAPL.
Both SPG and EQR have recently exhibited intraday volatility of over twenty percent in a single trading session, and most often this climaxes in the last half hour of trading. The moves of these securities are technical in nature and have nothing to do with news releases or any other fundamentals. They are being entirely manipulated by computer driven trading strategies and are further exacerbating the rampant crisis of confidence.
The final hour of every trading day is now feared, if not dreaded, by virtually every savvy market participant. Volume from 3-4pm EST has grown to greater than fifty percent of total daily volume in certain underlying securities and volatility has grown exponentially at the same time.
One example of this happened Monday, December 1. EQR was down $1.50 on five million shares at 3pm and closed the day down $6.58 on 10.6 million shares. In that last hour there was no change of any kind in the company?s fundamentals. As a market pundit recently commented, ?when markets make sharp movements without any discernable reason, investors lose faith in their ability to function properly.?
There is absolutely no economic purpose or value to these instruments.
We believe that trading in these securities in the way they are currently operating must be stopped immediately.
Purchasing a levered ETF (Ultra Long or Ultra Short) is akin to buying or selling a basket of securities in a particular market sector on margin. These vehicles, as described in the prospectuses, provide double the daily volatility of the underlying index that they track. ProShares, the major company (of three) that sponsors these funds must adjust for the price difference between the underlying components in the index and the move in the ETF each day. They accomplish this balancing act by buying or selling swaps and futures, which then must be reconciled in the market, against the underlying securities; hence the huge moves in individual stocks. Moreover, many of the ?players? using these vehicles do so on margin, further increasing the inherent leverage to double the 2x that it had already become.
An expense fee of .95% (of average daily net assets) is charged by the sponsors incenting them to grow both the funds individually and the number of such entities as quickly as possible. A few brokers, most notably Goldman Sachs, have provided a mechanism for day-end balancing which guarantees the sponsor?s 2x performance and provides a big spread (we hear, but don?t actually know, to be inordinately large) to the broker. While the brokerages can certainly argue that they are at risk, we are told that this risk is minimal and controllable relative to the inherent profitability.
It cannot be overstated that this is strictly a day-trading vehicle, as the prospectuses clearly state, and the only thing we believe they contribute is exaggerated volatility and yet another reason not to invest in our markets. This is vaguely reminiscent of the crisis produced by ?portfolio insurance.? Artificial factors not only dramatically increase volatility, they also raise the cost of capital and exacerbate the already negative consequences of the growing recession. And, because of the huge dislocation created by this artificial pricing (mark to market), on negative days Wall Street firms are forced to issue margin calls and liquidate customer positions, contributing to further instability.
Let?s take a brief look at the mechanics of how these ultra long and ultra short ETFs operate. For example, one purchases the URE, the ProShares Ultra Real Estate long ETF. In the last hour of the day, the sponsors of these ETFs must rebalance to insure that the ETF?s performance is 2x the performance of the underlying basket of stocks.
This is done by trading swaps and then the counterparty to these swaps must in turn buy or sell the underlying stocks in order to be hedged.
The more drastic the move in the market, the more pressure the ETFs are under to provide 2x the performance of the stocks, thereby exacerbating the moves in the underlying equities. This occurs simultaneously on both sides (ultra long and ultra short) doubling the force of the influence on the stocks in the basket. On down days the ultra short has to get shorter at the exact same time as the ultra long has to sell to end the day less long.
Let?s also look at the growth in volume in these Ultra ETFs and the corresponding explosion in volatility in the markets. Using the URE as an example again, in the last ninety days the average daily volume has gone from less than five hundred thousand shares a day to seventeen million shares a day. Notably during this time, the S&P 500 Index has had seventeen five percent up or down moves in a single day. The S&P has only had thirty-four five percent up or down moves in the last fifty-six years.
We need to pay immediate attention to this. One easy remedy would be for the SEC, which some now refer to as LONHO (Lights On Nobody Home), to simply reestablish the uptick rule, one which worked well for decades
(1934 Act) and which was eliminated for no discernable, rational purpose. However, there are many other things that should be considered.
We have allowed a serious moral hazard to emerge. As we explain in the ethics classes we teach, legality refers to what you can do, while ethics is about what you should do. We don?t pretend to know all the answers. What we are sure of is the necessity to recognize this issue and move as rationally and quickly as possible to eliminate the negative influence it increasingly exerts.
