Stop Worrying about Leveraged ETFs, Say Feds

February 12, 2015 James Heinsman Economic Barometer

Many in the market have had concerns that leveraged exchange fund trades could create market volatility – a new study explains that these concerns are misplaced. As two Federal Reserve Board economists explain, capital flows actually reduce the need for ETFs to buy and sell assets to match movements that are happening in benchmark indexes. This counters the potential for ETF Volatility to be a problem in the financial markets, as the authors explain.

The study was done by Fed economists Ivan Ivanov and Stephen Lenkey. As they wrote, “These products have been heavily criticized based on the belief that they exacerbate volatility in financial markets. We show that concerns about these types of products are likely exaggerated.”

As they explain in their conclusion, “ETFs are generally considered to be inexpensive and tax efficient investment vehicles. Because both the ETFs and their underlying portfolio are traded, they provide an ideal platform with which to examine the benefits of liquidity improvement. The latter occurs when the ETF is more liquid than its underlying portfolio. In this paper, we document the extent of liquidity improvement across a large cross-section of U.S. equity funds. Importantly, we investigate the role of liquidity improvement (and its two components) on ETF flows and mispricing. Our findings have broad implications for investors and ETF providers world-wide, particularly in Europe where ETF liquidity is fragmented across multiple exchanges, not to mention across multiple cross-listings, and where much of the trading in ETFs occurs over-the-counter. Our results demonstrate that liquidity improvement is not something that every fund can claim to offer. While the average fund has a positive liquidity improvement in spreads and in turnover, the liquidity improvement in spreads and in price impact are negative for the median fund, implying a significant amount of skewness in the cross-section of funds. There is also a great deal of variations across sub-groups of funds based on size and sector.”

For more in-depth information, you can read their white paper.

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