We're out late today, due to the Memorial holiday yesterday. And what a return to reality, huh? Dow up 200 today following a nuclear test in North Korea over the weekend.
What in the world is going on, IR professionals? Recalling Sherlock Holmes' principle that once you eliminate the impossible, what remains, no matter how implausible, is your answer, we have an idea. The implausible truth is that some market participants have gotten gobs of free money and have used it to feed the sort of leverage that contributed to the enormity of our debacle last autumn.
Let's take one piece of the puzzle: leveraged Exchange Traded Funds (ETFs). These are instruments that trade like stocks but offer a heightened return. For instance, Direxion offers the Large Cap Bull 3x Shares Russell 1000 ETF 300%, one of an exploding array of leveraged ETFs. This one trades under BGU and aims to deliver 300% of the move in the Russell 1000 in a bull market. In theory, if the Russell 1000 is up 3%, this ETF would expect to be up 9% in value.
How do you get triple the return without putting up more money? We had a web meeting Friday the 22nd with the panelists for our NIRI National session June 8 in Florida (see last week's Map for more on it), and they told us some astonishing things about the way leveraged ETFs cause volatility late in the trading day. I also slogged through a 24-page white paper by Minder Cheng and Ananth Madhavan of Barclays called "The Dynamics of Inverse and Leveraged Exchange Traded Funds," and several other articles. Bottom line, leveraged ETFs apply counterparty swaps, and the counterparties rebalance assets – marking to market essentially – late in the trading day.
These ETFs tend to have high management fees, because they're paying for swap contracts that offer big returns if the ETF's strategy comes to fruition. It doesn't take a genius trader to figure out that counterparties like big Primes (Goldman, Morgan, Merrill Lynch/BofA) awash in free Treasury capital are going to write a lot of these contracts, and then rebalance assets to keep risks within acceptable parameters.
So if the Russell was down last Friday, and all the leveraged bear ETFs had to cover, and then that changed the dynamics of the market today, and in turn, the counterparties behind leveraged bull ETFs had to cover today, and traders front-run rebalances…well, keep this up and what happens? In the short term, these features breed extreme volatility that feeds itself much like a person crossing a swinging foot bridge.
This is a confluence of several key factors: the Federal Reserve is essentially giving money away for free by keeping overnight rates between zero and 25 basis points. Banks can take big risks with free money that's not theirs. So they underwrite what are essentially gambles in ETF instruments. Investors greedy for returns in unpredictable markets pour money into these vehicles. And we create all over again what wrought the AIG mess, except now we have trillions more in currency circulating.
We can't help but think of the First Rule of Holes: when you're in one, stop digging.
Margaret E. Wyrwas - Knight Capital Group, Inc. (Nasdaq: NITE)
Senior Managing Director, Corporate Communications & Investor Relations
Equity Analysis™ subscriber since March 2007
"In global markets driven by automation, changing market structure regulation and dynamic investment objectives, today's investor relations professionals require new data points in order to remain relevant and add value in their company's quest to reduce its cost of capital."
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