Volatility, Thy Name Is E.T.F. - By Andrew Ross Sorkin
Did you watch the markets on Monday? In the last 18 minutes of trading, the Standard & Poor’s 500-stock index jumped more than 10 points with no news to account for the rally. If you were left scratching your head, you were not alone.
Almost every day there is an article in the newspaper trying to explain the stock market’s wild swings, or volatility, and often the explanation is inconclusive, involving everything from Europe’s banking problems to new fears of recessions.
Through the summer and into the fall, I, too, have been pondering the gyrations in trading, especially the late-day sell-offs and rallies that seem always timed perfectly to coincide with the closing bell. Rarely do the rallies or sell-offs, which invariably start after 3 p.m., justify 3 to 4 percent moves in the indexes. The swings have a deleterious effect on the markets because they undermine confidence and investors start sitting on the sidelines.
And then I started talking with investors like Douglas A. Kass, a longtime Wall Street denizen who is the founder and president of Seabreeze Partners Management.
He says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or E.T.F.’s.
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Mr. Kass, who has written about this topic for TheStreet.com, may be right: at the end of every day, leveraged E.T.F.’s have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the E.T.F. made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged E.T.F.’s use options, swaps and index futures to keep themselves in balance.
You might consider the E.T.F. the new derivative.
“It is these derivatives and not the phenomenon known as high-frequency trading (H.F.T.) — commonly critiqued as contributing to the ‘flash crash’ of May 6, 2010 — that pose serious threats to market stability in the future,” Harold Bradley and Robert E. Litan of the Kauffman Foundation wrote in a controversial white paper last year. “The S.E.C., the Fed and other members of the new Financial Stability Oversight Council, other policy makers, investors and the media should pay far more attention to the proliferation of E.T.F.’s and derivatives of E.T.F.’s.”
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I took an informal poll of a half dozen brand-name fund managers and virtually all of them agreed with Mr. Kass. But some of them said that high-frequency traders, which themselves trade E.T.F.’s, could be magnifying the problem.
“We know E.T.F.’s are the dominant factor in the marketplace,” Mr. Kass said. “In the ’70s and ’80s it was the mutual funds, in early 2000s it was the hedge funds. Now it’s the algorithms running the E.T.F.’s.”
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