A Retort to Andrew Ross Sorkin on ETFs

In a late night post on New York Times Dealbook, Andrew Ross Sorkin, wrote a post talking about the "evilness" of ETFs. Sorkin interviewed Doug Kass, of Seabreeze Partners Management and other hedge fund managers about leveraged ETFs, and the supposed volatility they have caused in recent weeks and months, especially towards the end of the trading day. He also drummed up some white papers both for, and against ETFs and how they play a role in market volatility. Mr. Sorkin interviewed Kass, and Kass said, “They've have turned the market into a casino on steroids. They accentuate the moves in every direction — the upside and the downside.” Kass has written about this subject extensively on TheStreet.com. The founder of DealBook, a blog purchased by the New York Times NYT, also got details from others in a white paper on the topic. The paper was penned by Harold Bradley and Robert E. Litan of the Kauffman Foundation, and they wrote, “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. 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.” Sorkin also notes that Barclays Global's research department did a study before the flash crash in May 2010. Barclay's seems the same thing, that these leveraged ETFs create systemic risk due to the leverage and ability to “amplify the market impact of all flows, irrespective of source.” On the other side, Sorkin quoted a report from William J. Trainor Jr., a professor at East Tennessee State University, who said that market volatility has nothing to do with the ETF re-balancing. “Intra-daily volatility in time periods not associated with rebalancing saw the same spikes in volatility as the last 30 minutes did,” Trainor Jr. wrote. This is definitely a controversial topic, but you have to take into account that we are living in extremely volatile times right now. These products were around before the financial crisis started (some say it started late in 2007, others say in the summer of 2008). The moves up and down at the end of the days were not nearly as high and dramatic, or as frequent, as they are now. The volatility or fear index, as measured by the CBOE Volatility Index (VIX), is over 33, and has remained over 30 since the beginning of August, when the American debt issues and worries about Greece really started to reemerge in the market place. Since then, the U.S. has lost its AAA rating from S&P, and almost defaulted on its debt. The worries about Greece also popped up where it looked like it may actually default. Look at this chart showcasing the VIX over the past year. We did not see outsized moves at the beginning or end of the day while the VIX was in the mid teen's. It was a fairly benign market. Some may argue the relative calmness in the markets was due to the Federal Reserve intervening in the markets with its quantitative easing program. What about in 2008, when these leveraged products were introduced and the financial crisis was underway? Were the products, which were just in their infancy, responsible for the major swings up and down, back then? No, of course not. It was market psychology and the spreading of fear. The U.S. markets felt that another Great Depression was right around the corner, especially when Congress failed to vote in favor of TARP the first time. The Dow Jones dropped over 700 points that day and the volatility index was more than twice what it is now. Some of these leveraged ETFs were introduced in November 2008, including the Direxion 3X Daily Bull Fund FAS and Direxion 3X Daily Bear Fund FAZ, and these funds could not have had the assets under management to really affect market moves to the extent we were seeing in late 2008, and 2009. Since 2008, we have seen the number of these funds grow significantly, and add assets as investors and traders try to turn a profit. It does not make sense that in August, all of a sudden we saw the volatility increase in equities because of these leveraged ETFs. The Federal Reserve ended QE2 in June. Market psychology was severely threatened in August, and continues to remain very fragile. That is why we see outsized gains or losses on rumors from Europe. Everything is being magnified by a fragile market. People are much quicker to react to negative or positive news now and will continue to do so until a solution is found. Leveraged ETFs might be popular to blame, but they are not the reason. The problem is in our heads. Not our products.