Are ETFs Driving Late-Day Turns?
Leveraged Vehicles Seen Magnifying Other Bets; Last-Hour Volume Surge
WSJ 12/15/2008
By TOM LAURICELLA, SUSAN PULLIAM and DIYA GULLAPALLI
Many traders are blaming high-octane exchange-traded funds for the market's wild moves in the last hour of trading.
They're called "leveraged" ETFs and are designed to magnify bets on broad stock indexes or more narrow sectors of the market, such as financials or real-estate investments.
The leverage aspect, usually achieved through underlying swaps or options, means a holder earns or loses two or three times the returns on the funds. ETFs are typically baskets of securities traded on exchanges, and the leveraged kind are designed either to profit when stocks rise or when they fall.
The final hour of trading has become significantly more active. In November, an average 26.2% of trading volume in the stocks in the Standard & Poor's 500-stock index took place in the final hour and 17.1% in the last 30 minutes, according to data from Credit Suisse. That's a much higher share than before: In 2006 and 2007, 20.7% occurred in the last hour and 12.9% in the last half hour.
This surge in trading has come amid big moves in prices. In many days, prices have been moving three or four percentage points in the last hour -- moves that not very long ago would have been extreme for an entire day.
On Oct. 15, for example, the S&P 500 lost 2.3% in the last 30 minutes and on Nov. 20 the index lost 3.8% in the final hour. Credit Suisse data show about half the big swings were significant extensions of moves already under way and about half were big reversals.
On eight of the 10 worst days for the S&P 500 since Sept. 1, 29% or more of the move took place in the final hour; on three days, more than half the selloff occurred after 3 p.m.
Certainly, the market's volatility has its roots in the financial crisis, tremendous uncertainty about corporate earnings and an economy in recession. But market swings have been magnified in the last hour of trading, from 3 p.m. to 4 p.m. in New York, and one explanation lies in these ETFs.
Some of the most popular leveraged ETFs debuted in 2006 and more than two dozen launched last year. There are now more than 100 leveraged ETFs available in the U.S., including ones tracking currencies and bonds.
On many days, leveraged ETFs are now some of the most actively traded securities in the stock market. They're popular among hedge funds and institutions as easy ways to make an aggressive, outright play on stocks or hedge a portfolio against unwanted market moves. But they have also become popular among fast-trading pros who piggyback on the ETFs as a way to make a quick profit in the final hour of the day.
Michael O'Rourke, market strategist at brokerage BTIG LLC, says ETF trading helps explain why there have been so many days where an up or down move suddenly picked up speed for no apparent reason. Their trading activity "reinforces a trend once it starts in motion," he says.
Will Weinstein, chairman of Conifer Securities, believes trading connected to the ETFs is "the primary source of volatility in stocks covered by these levered ETFs by a lot." These funds, he says, "are making an already unstable environment much, much worse."
ETF companies say they see no hard evidence that the market's swings have anything to do with their products. "Obviously all transactions in the marketplace have an impact," says Michael Sapir, chief executive of ProShares, one of companies offering leveraged ETFs. Yet he says the idea that leveraged ETFs cause the end-of-day ups and downs is "utter postulation."
Bigger influences in the huge last-hour moves, some say, is selling due to redemptions in large mutual funds and hedge funds, plus a general unwillingness of market-makers and other traders to keep positions or orders open overnight. These dwarf leveraged ETF activity, according to Dan Mathisson, a managing director at Credit Suisse. "It's the finish-the-ticket theory," he says.
Leveraged ETF trading has exploded. Over the last three months, average daily trading volume in the UltraShort Financials ProShares -- which bets against financial stocks -- was 27 million shares, up from about 8 million in 2008's first three months. On Friday, 32 million shares of the UltraShort Financials ETF changed hands, compared with 24 million shares of Wal-Mart Stores Inc. The UltraShort S&P500 from ProShares has been averaging 60 million shares a day for the last three months.
But even with that kind of volume, how could these ETFs drive a market where billions of shares change hands every day? The answer, many say, has to do with the hedging by dealers who make markets in the funds and traders who pile on to make a profit.
Unlike traditional ETFs, which are backed by baskets of individual stocks, leveraged ETF shares are usually created by using swaps or options. Brokers who sell the sponsors these funds must then either buy or sell the underlying shares covered by the ETF at the end of the day. And just as they magnify returns for investors, the amounts needed to hedge are multiplied.
What's more, both the levered short and long ETFs create trading in the same direction. Here's how: Take a bull market ETF designed to deliver twice the returns when stocks move higher. Starting with a base value of $100 per share, a broker who sells the ETF to a client will have an exposure to the market of $200. If the market falls 10%, the value of the ETF falls 20% to $80 and the broker's exposure falls to $180 once the market's move is factored in. To square the books, the broker sells $20 of the underlying stocks at the end of the day.
Then consider $100 of a double-leveraged bear market fund, which leaves a dealer with $200 worth of short exposure. If the market falls 10%, the fund rises in value by 20% to $120. The dealer's short exposure is now $180 once the market's move is factored in. As a result, the dealer must sell $60 to get back in line.
As the market grew more volatile in September, Wall Street proprietary trading desks began piling onto the back of the trade knowing that the end-of-day ETF-related buying or selling was on its way. If the market was falling, they would buy a short ETF and short the stocks or the market some other way. If the market was rallying, they would buy a bull fund and go long.
Dan Connolly, a proprietary trader in Chicago, says he frequently keeps a window up on his computer tracking trading on the UltraShort Financials ProShares ETF. If the fund is down significantly as the final hour approaches, he'll put in orders to buy shares betting that the declines in financial stocks will be extended before the close. "It's a momentum play," he says.
One example of a big ETF-inspired price swing came Dec. 1, when Conifer partner Robin Poore noticed an unusual volume spike in shares of Equity Residential, a real-estate investment trust owned by Conifer's money management unit. Equity is covered by both Proshares Ultra Real Estate long and Ultra Real Estate short ETFs. On that day, shares of Equity Residential fell to $23.85 from $29.83, with more than five million of its total 10.6 million in volume that day coming between 3 p.m. and 4 p.m. Prior to this fall, Equity Residential's daily volume rarely rose above five million shares.
According to calculations by Mr. O'Rourke at BTIG, trading on Dec. 1 in the ProShares leverages short fund equaled 52% of the volume in Equity Residential shares. It's a similar story for many financials, Mr. O'Rourke notes; since the beginning of September, daily trading volume on leveraged financial ETFs has equaled 56% of the activity in U.S. Bancorp shares.
Mr. O'Rourke notes that, lately, with the market showing some stability, last-hour swings haven't been as violent. But, he says, with the growing use of the ETFs it's likely that the next time there uncertainty in the market "we'll see those moves again."
Write to Tom Lauricella at tom.lauricella@wsj.com, Susan Pulliam at susan.pulliam@wsj.com and Diya Gullapalli at diya.gullapalli@wsj.com |
