Occasionally, you’ll see a mainstream financial media article about leveraged ETFs, but such pieces are surprisingly rare considering how amenable the topic is to hyperbole.
Generally speaking, the more conducive a story is to editorial embellishment, the more coverage you’ll see, but the big outlets have missed the boat on this one.
The figure on the left, below, is a rather stark reminder: Total AUM in these mass market products has increased sevenfold over the past decade.
The figure on the right shows you the attendant increase in the implied rebalancing needs emanating from that swollen AUM.
I realize this comes across as esoteric and in some sense it is, but it’s becoming more important as a source of what Nomura’s Charlie McElligott describes as “synthetic negative gamma.”
What the hell does that mean? Colloquially, it means that when these things execute the daily mechanical reset required to deliver on their levered performance promise, they act as a directional accelerant.
The red-shaded annotation on the right, below, from the same Tuesday McElligott note spells it out. The EOD rebalancing “feeds the market’s prevailing directional.” Conceptually speaking, it’s a pro-cyclical flow. That’s not the most accurate term, but if you’re fluent in macro but not in markets, that’s an easy way to quickly grasp the concept.
As Charlie’s yellow-shaded annotation emphasizes, the concentrated nature of those products’ underlying allocation makes this dynamic even more potentially impactful than it already is by the very nature of leveraged exposure. Almost all of the product AUM’s in the tech leadership. Stripping out index-linked SPX products, that figure’s still almost 70%.
The overarching point is that this is a meaningful (note the emphasis) source of accelerant potential, and it goes a ways towards explaining why rallies and selloffs seem to snowball late-day. As McElligott put it in a Bloomberg article a year ago, as product AUM swells, “they’re simply going to have more to move on their mechanical end-of-day rebalancing.”
And remember: Nothing happens in a vacuum. In the same Tuesday note, Charlie wrote that people are getting curious again “as to how the ‘mania’ into Equities product may be tying back into the UST repo squeeze.”
“Due to the massive popularity of US equities leveraged ETFs and the lucrative nature of getting those financing lines and swaps in place with the ETF providers across sell-side desks, there [may be] some interplay with dealers then re-allocating balance sheet from UST Repo finance to Equities finance,” he wrote.
Oh s@@t. Yet another accelerant. I’m old enough to remember the ~26% drawdown in one day in the early 80’s.
Thank you once again for alerting us to these barely acknowledged “under the covers” forces which impact day-to-day and week-to-week real & significant market flows.
Once upon a time this stuff didn’t matter very much, if at all. Now they drive share prices.
Your readers, including me, owe you a big ol’ thank you.
H-Man, sometimes when you cook an omelette, you lose control (to much heat, to much cheese, to much of everything) and it turns into scrambled eggs with stuff. It won’t take much for this market to become scrambled eggs but with really ugly stuff.
Do these things need to exist?
I know, slippery slope, which leads to “do we (portfolio managers) need to exist” and of course we do, being truly vital to human welfare in some way that I can’t quite articulate but believe must exist.
No, these things don’t need to exist. Anybody who “needs” leverage knows how to get it. Anybody who doesn’t know how to get leverage doesn’t need it.
Not currently, but in the past I had 100% of my portfolio in leveraged for weeks at a time. I had to get out when I couldn’t figure out why the inverse ones wouldn’t catch up if the market had been going up. I guess this was the explanation I needed. Since I am getting ready to start again, after being out of the market all year.
Based on what I can glean from your comment, it sounds like you don’t understand the mechanics of how these products actually work. Don’t feel bad, almost no one does. Suffice to say you should take an evening and read a few prospectuses so you can kinda get a feel for what they do, how they do it and, mostly importantly, why they may not do what common sense seems to suggest they “should” in certain circumstances. If you just buy these things without truly understanding the basics, they will perplex you and vex you regularly. Once you understand the basics, I can almost guarantee you will never want to be anywhere near them ever again.