Activist investor Carl Icahn and BlackRock founder Larry Fink have clashed over the merits of exchange traded funds, but they agree on one subject: ETFs that use derivatives to juice up returns for investors are a bane.
In the wake of the turmoil in US stocks last week — which was deepened by the collapse of two exotic, derivatives-based exchange-traded products — the two have echoed each other in condemning these complex products.
“Inverse and leveraged exchange-traded products are not ETFs, and they don’t perform like ETFs under stress,” said BlackRock, one of the three companies that dominate the ETF industry in the US. Mr Icahn, who opposes ETFs more broadly, this week took particular aim at leveraged ETFs, calling them “crazy”.
The $5tn passive investment industry that has assailed stockpickers over the past decade is primarily made up of exchange traded funds, but there is also a number of exchange-traded “notes” that are similar but subtly different from the better-known ETFs. In the industry they are collectively known as ETPs, even though many use the term ETF interchangeably with ETP.
As global stock markets have rallied over the past two years, leveraged ETPs, which use derivatives to juice up the returns of the index they are tracking by up to three times, have had robust growth. At the end of 2017, there were 883 leveraged and inverse ETPs — those that seek to do the opposite of a particular index — with assets of more than $80bn, up nearly 20 per cent from 2016, according to ETFGI.
The products have long been controversial, with critics pointing out that they are complicated instruments only suitable for sophisticated traders, rather than retail investors who often use them.
The sudden collapse of two Vix-linked ETPs last week is intensifying the scrutiny, as the long stretch of calm markets ends. Although these funds were not typical leveraged or inverse ETPs, they were built on derivatives tied to Vix — itself an index based on US equity options.
“Where there is retail investor pain, regulatory scrutiny follows,” Jamie Selway, managing director at ITG and at one point a top contender to run the SEC’s markets division, noted.
Indeed, Switzerland’s regulator has already contacted Credit Suisse about the ETP it managed, which was closed after losing 95 per cent of its value last week. The US Securities and Exchange Commission has now also been in touch, according to people familiar with the matter. The Swiss bank and the SEC declined to comment.
ProShares, which manages a short-Vix ETP that narrowly survived the ructions, said that the performance of its fund had “reflected the changes in the level of its underlying index”. In a statement to the Financial Times, the company added that it had seen “no credible analysis that concludes leveraged and inverse ETFs have a material, harmful effect on the markets”.
A sharper focus on these riskier vehicles has also underlined how influential and big they have become. The five largest Vix ETPs, for example, enjoyed average daily trading volumes of more than $2bn last year, making them more liquid than the stocks of JPMorgan Chase or Google parent company Alphabet. The average daily volumes of leveraged and inverse ETPs climbed to nearly $10bn in November, according to the latest figures from ETFGI.
By comparison, about $4bn of Apple shares traded a day on average last year. That means that $80bn of leveraged and inverse ETPs are collectively far more actively bought and sold than Apple, an $830bn company.
The defenders of these vehicles say that they are primarily trading tools rather than investment vehicles you buy and hold, and argue the risks are clearly communicated.
“We provide very clear disclosure about how these products work,” said Sylvia Jablonski, managing director at Direxion, a provider of leveraged and inverse ETPs, although no Vix-linked funds. “It democratises the ability to get leverage.”
But even the creator of the Vix index that underpinned these volatility-linked funds argues that US regulators should investigate the entire ecosystem.
“What happened is almost unprecedented. They pretty much have to investigate with gyrations this large,” says Robert Whaley, a professor at Vanderbilt University. “But the investigation should go more broadly and not just look at XIV [one of the funds that was wiped out]. They should look at the inverse and leveraged products more broadly.”
Prof Whaley said derivatives, including those linked to the volatility index he created, are a useful tool for big asset managers, but their wider proliferation through ETPs raised questions over market integrity.
“We’re putting sophisticated trading tools in the hands of retail investors,” he says. “We have to think about why we are approving these things.”
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