Fed issues leveraged ETF warning

imagesCourtesy of Chris Flood

Trading activity by leveraged exchange traded funds during periods of high volatility could trigger a crash in the US stock market, according to a warning by the Federal Reserve.

Leveraged ETFs (LETFs) use derivatives to provide a multiple of the daily returns of an index. When the stock market rises, leveraged ETFs need to buy more of the underlying index to make sure they deliver the required return.

 “Rebalancing by LETFs in response to a large market move could amplify the move and force them to further rebalance, which may trigger a ‘cascade’ reaction,” said Tugkan Tuzun, an economist at the Federal Reserve.

US regulators have repeatedly said that leveraged and inverse ETFs are not suitable for long-term investors.

However, the analysis by the Federal Reserve elevates these criticisms further, suggesting that the risks of LETFs have not been fully appreciated.

LETFs have been widely criticised for adding to end of day price volatility as their trading activities concentrate in the last hour of the trading session.

In a research paper published in July, the US central bank, said that trading by LETFs in the last hour of the day could cause “disproportionate price changes” and that if the stock market were to close sharply lower, this could affect investor confidence and lead to large overnight withdrawals.

The Federal Reserve also drew an explicit comparison between LETFs and the portfolio insurance strategies that contributed to the US stock market crash in October 1987.  For the full article from FT.com, please click here