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