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leveraged ETFs

The Big Short: Leveraged ETFs, By David Miller

The Big Short is coming to a theater near you soon, but the hedge fund industry’s cool kid of the year David Miller has traded ahead of his peers by exploiting and being short of the popular ETF industry product: leveraged ETFs  and “inverse ETFs”; products that are typically powered by futures contracts so as to magnify returns of a move in a particular index.

Exchange-traded funds that employ derivatives or futures contracts have [rightfully so] been the subject of increasing scrutiny of late, a topic discussed more than once by MarketsMuse. As tweeted earlier today by our curators, the SEC which is notorious for chasing horses after they’ve left the barn, is now taking an even deeper dive towards determining the efficacy and credibility of these testosterone-charged ETFs—albeit putting the Genie back in the bottle will prove non-trivial for regulators. That said, one macro strategy-centric hedge fund manager is exercising his fund’s trade strategy options by leveraging the short-comings of these products by systematically shorting a laundry list of the so-called 2x and 3x return products, and he’s been smiling all the way to the top of the list of 2015’s best performing HF managers.

As reported by Reuters’ David Randall, the $155mil AUM Catalyst Macro Strategy fund, run by 35-year old David Miller is the cool kid of the year for using exchange-traded options to short leveraged exchange traded funds that offer two or three times the daily positive or negative return of an index and which have become increasingly popular among hedge funds and other traders as the broad U.S. market has flatlined. Leveraged ETFs have seen inflows of $9.5 billion this year, according to Lipper data.

Here’s the opening excerpt from Reuters’ reporting..

david miller catalyst macro…. Miller’s $155.6 million Catalyst Macro Strategy fund, has posted returns of nearly 47 percent over the last year by focusing on the flaws of levered exchange-traded funds. That performance makes Miller’s fund the best performer among all actively-managed equity funds tracked by Morningstar this year, and nearly 20 percentage points greater than the next-best performing fund.

The average hedge fund, by comparison, gained 1.1 percent over the same time, the lowest return since the average loss of 5.4 percent in 2011, according to BarclayHedge.

At the heart of Miller’s strategy is a bet against what he calls “structurally flawed” ETFs. He has a list of approximately 100 such ETFs, nearly all of them leveraged, that he uses as the basis for his trades.

Miller’s base case is that most leveraged ETFs are poorly designed because the nature of compounding wipes out their gains over time.

An investor who puts $100 into a two-times leveraged fund realizes a gain of 20 percent if the index it tracks goes up 10 percent in one day. Yet if the same index goes down 9.1 percent the next day to fall back to its starting point, the same investor who had $120 will realize a loss of 18.2 percent – or $21.84 – and be left with just $98.16.

Miller uses options to hedge his holdings, focusing on making bets that an ETF will have choppy trading rather than sprinting off in any direction, a strategy that he says limits his losses.

For example, he has a net short position on both an ETF that offers a triple positive return of an index of Russian stocks and one that offers a triple negative return of the same index based on the idea that Russian stocks tend to be volatile.

Indeed, both funds are down this year significantly, while their underlying index, the Market Vectors Russia ETF index (NYSE:RSX), is up 22 percent. The bullish fund down 27.6 percent while the bearish fund is down 66.9 percent.

To be sure, the strategy is not foolproof and carries risks of its own, including high trading costs incurred from frequent options trading and the risk that a leveraged ETF goes on a prolonged run beyond Miller’s strike price, leaving him on the hook for theoretically unlimited losses.

At the same time, the U.S. Securities Exchange Commission proposed a rule on Friday that would force ETFs to limit their derivatives exposure, potentially forcing most leveraged ETFs to shut down [L1N1401IW]. In that case, Miller said he would be forced to pivot his options strategy to focusing on “inconsistencies” in the futures market for commodities.

So far, Miller has been able to hedge away most of his losses. He has a net short position on the ProShares Ultra VIX Short-Term Futures ETF (NYSE:UVXY), a fund that returns two times the daily performance of the S&P VIX Short-Term Futures index.

The fund shot up more than 11 percent on December 9 of this year. Yet Miller is willing to look past such daily losses and focus on the long-term tendency of leveraged ETFs to “decay,” he said. The same fund he has a net short position on, for instance, has a 78 percent decline for the year to date.

Fund experts say that Miller’s strategy of using options to short leveraged ETFs is unique, but does not have a long enough track record to be judged as anything more than a fluke.

“This is quite rare to find any fund that is using this as part of their strategy,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.

At the same time, Miller’s short track record is its own risk, he said. His strategy “has worked out excellently this year for this fund, but it’s still only one year of performance,” he added.

Miller, meanwhile, says that he has such a long list of what he calls poorly thought-out ETFs that he feels no need to hope that the fund industry keeps introducing more of them.

“There are so many terribly designed products out there already,” he says.

(Reporting by David Randall, with additional reporting by Saquib Ahmned; editing by Linda Stern)
Read more at Reutershttp://www.reuters.com/article/us-catalyst-fund-etf-idUSKBN0TW0TX20151213#mdFJfVOuVEKxhbSp.99

nomura suspends leveraged ETF new creations

Nomura Says Sayonara to New Leveraged ETF Creations

Sayonara City As Japan Getting Crash Course in Leveraged Returns With Nikkei ETF

MarketsMuse ETF update courtesy of Bloomberg LP Oct 15–Nomura Asset Management Co. said it would suspend on Friday the creation of new shares in a large leveraged exchange-traded fund, as well as two others, citing liquidity concerns.

The move applies to the Next Funds Nikkei 225 Leveraged Index Exchange Traded Fund (BBRG Ticker: 1570 JP Equity <GO>), which has about ¥734 billion ($6.2 billion) in assets. The fund’s shares are up about 8.7% this month. Nomura said shares will continue to trade.

“The temporary suspension has been determined, considering the current situations of fund management including the liquidity of the underlying Nikkei 225 futures and the total assets under management of three ETFs,” Nomura posted on its website. The firm will continue to receive redemptions, it said.

A Nomura representative wasn’t available to comment.

The decision highlights an increasingly warned-about side effect of exchange-traded products’ growing popularity: a mismatch between the liquidity of some funds and their holdings.

The Nomura decision also highlights concerns about leveraged products, which provide investors with outsize exposure to certain asset classes, employing tactics such as borrowed money and derivatives. The $6.2 billion fund provides investors with two times the exposure to the Nikkei 225.

The products have been popular in the U.S., but the size of Nomura’s Next Funds Nikkei 225 Leveraged Index ETF is larger than any such leveraged exchange-traded product in the U.S., said Dave Nadig, director of ETFs at financial-data provider FactSet. There are close to 1,800 exchange-traded products listed in the U.S., and about 230 of them are leveraged, he said.

Regarding how leveraged funds operate, Mr. Nadig said: “The math makes people’s heads hurt.”

It’s not the first time an exchange-traded product has run into obstacles because of its own popularity. Credit Suisse Group AG had to suspend the creation of new stock in the VelocityShares Daily 2x VIX Short-Term ETN in February 2012, after demand for the security hit a limit set when the product was created in 2010. Barclays Plc also halted issuance in its iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN in August 2009.

For the full story from Bloomberg LP, please click here

How Savvy Hedge Funds Exploit ETF Products-Supposedly

While equities markets have zig-zagged since late summer with lots of volatility,  leading to pretty much no change in major indices since late August, news media outlets have put their cross hairs on the ETF industry, which has been battered with criticism consequent to out-0f-context pricing that has riddled opening bell markets during recent spikes in volatility.  CNBC pundits have invited an assortment of geniuses to explain, defend or attack ETFs for days, including 30 minutes dedicated to the topic mid-day yesterday.  The industry print publications have been repurposing each other’s copy with similar themes for days, and the SEC and other alphabet agencies are purportedly ‘investigating’ the ETF industry as a consequence of the recent disruptions.

For equities market experts who are fluent in exchange-traded funds, which are nothing more placeholders for bespoke basket trading strategies–you know that the notion of disruptions in pricing of the cash product aka the ETF could easily happen whenever there is a dislocation in the underlying constituents. Its a caveat emptor type of product. But, somehow, this simple concept has been lost on everyone, except of course by ‘savvy hedge fund managers’..and what a surprise, one HF name now being mentioned for exploiting ETF products is none other than Steve Cohen.

Here’s an excerpt from today’s WSJ “Traders Seek Ways to Benefit From ETFs’ Woes…In some cases, gains come at expense of individual investors”….–which is arguably best suited for college freshman taking elementary classes. According to one trader interviewed by the MarketsMuse Curator, “If there is any SEC-certified RIA or any institutional investor who doesn’t understand this product and the related nuances [and believes the WSJ article was informative], your license should be stripped.”

Here’s an excerpt from today’s WSJ story by Rob Copeland and Bradley Hope Continue reading

Leveraged ETFs Chapter 12: Levered and Lightly Levered: Which Direxion To Choose?

MarketsMuse update courtesy of extract from Olly Ludwig’s ETF.com profile of Direxion Shares’ latest levered product. Continuing in the direction of embracing RIAs, Direxion is hoping the latest incarnation will further innovate and provide investment advisors with a new tool. Here’s the opening from ETF.com’s profile….

Olly Ludwig, ETF.com

Just when you thought that the leveraged ETF niche has been carved out and accounted for, New York-based Direxion Shares has come out with what it calls “lightly levered” ETFs that have 1.25X exposure.

To hear Direxion President Brian Jacobs speak to this new ripple in the world of leveraged ETFs, the company aims to give investors a more easily managed investment tool than the 2X and 3X ETFs that have ruled the leveraged roost so far. But, no less, Jacobs told ETF.com that Direxion is looking to reinvent the leveraged ETF for an advisory channel increasingly focused on asset allocation in portfolio construction.

For the full story from ETF.com, please click here


Fed Does Walk Back On Leveraged ETFs; Now Endorsed in US Govt Study

MarketsMuse editor note: For those not familiar with leveraged ETFs, before reading this special column, you’ll want to get up to speed with Investopedia’s defintion, otherwise, ETF industry experts and observers have new ammunition in which to debate the pros and cons of leveraged ETF products. If you find that your debate with peers becomes too spirited, you might change the channel and duel about the merits of shale oil fracking..

Leveraged and inverse ETFs, which some industry experts have labeled “Weapons of Financial Destruction” aka “WFDs” have come under heavy criticism as potentially exacerbating volatility in financial markets, are not the danger that critics have made them out to be, concludes a preliminary study from U.S. Federal Reserve researchers.

“..Leveraged and inverse exchange-traded funds (ETFs) have been heavily criticized for exacerbating volatility in financial markets because it is thought that they mechanically rebalance their portfolios in the same direction as contemporaneous returns. We argue that these criticisms are likely exaggerated because they ignore the effects of capital flows on ETF rebalancing demand. Empirically, we find that capital flows substantially reduce the need for ETFs to rebalance when returns are large in magnitude and, therefore, mitigate the potential for these products to amplify volatility. We also show theoretically that flows can completely eliminate ETF rebalancing in the limit.”  US Federal Reserve study, November 2014
Continue reading

BlackRock CEO Roils ETF Audience: “Leveraged ETFs Can Blow-Up The Industry”

reuters logo

Courtesy of Reuters News

May 28 (Reuters) – BlackRock Inc Chief Executive Larry Fink said on Wednesday that leveraged exchange-traded funds contain structural problems that could “blow up” the whole industry one day.

Fink runs a company that oversees more than $4 trillion in client assets, including nearly $1 trillion in ETF assets.

“We’d never do one (a leveraged ETF),” Fink said at Deutsche Bank investment conference in New York. “They have a structural problem that could blow up the whole industry one day.” (Reporting By Tim McLaughlin; Editing by David Gregorio)


With Volatility Rising, Beware The Leveraged ETF

  forbes logoThe following extract from Forbes.com is courtesy of Forbes and their contributing writer Bill Feingold, co-founder of Hillside Advisors. Bill is an alumni of the convertible bond team at GoldmanSachs, Wellesley Investment Advisors and worked for 2 hedge funds specializing in “converts.” He’s also an alum of Wharton (MBA) and Yale (BA), where he also taught “Market Psychology and the Truth about Derivatives.”  MarketsMuse Editor Note: Bill is biased towards the use of convertible bonds vs. use of certain types of exchange-traded-products. Our staff, which is well-versed in convertible bonds, ETPs (as well as underlying products that use futures products) and derivatives found Feingold’s most recent article re: leveraged ETFs a compelling read, hence the ‘share’ with you.

Some who read my posting Wednesday, in which I reiterated my five-year-old argument that convertibles make better long-term investments than leveraged ETF’s, asked me to illustrate how leveraged ETF’s can work against you in ways that may not be immediately obvious.  With market volatility picking up—exactly the kind of environment in which these products do the most damage—I thought it was worth a quick example.

Consider a stock trading at 100. Let’s say you buy an ETF designed to provide twice the daily return, in the same direction as the underlying shares. We will say the ETF is also at 100 when you buy it.

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