Leveraged ETFs and Portfolio Insurance

Very interesting new research paper out from Barclay’s Global detailing some of the consequences and risks flowing from the growth in assets under managements at leveraged ETFS (i.e., those funds that try to produce anywhere from -3x to +3x the return of a particular benchmark on a daily basis). Here is a snippet that caught my eye in particular:

Inverse ETFs in particular have a magnified hedging demand relative to their long counterparts (e.g., as shown above, a 2x inverse ETF has the same hedging multiplier as a 3 leveraged long ETF) The analysis above shows leveraged and inverse ETFs amplify the market impact of all  flows, irrespective of source. Essentially, these products require managers to "short gamma" by trading in the same direction as the market. There is a close analogy to the role played by portfolio insurance in the crash of 1987. The magnitude of the potential impact is proportional to the amount of assets gathered by these ETFs, the leveraged multiple promised, and the underlying index’s daily returns.

In short, leveraged ETFs, as assets increase, represent a new source of systemic risk in the market as their managers rebalance them at market close every day.


The Dynamics of Leveraged and Inverse Exchange-Traded Funds
Minder Cheng and Ananth Madhavan
Barclays Global Investors