Leveraged ETF Rebalancing: It's Not As Bad As It Seems

A frequent criticism of leveraged exchange-traded funds is that these ETFs can, in volatile market environments, deviate wildly from their stated objectives.

The scenario, one that has been brought up countless times since leveraged ETFs garnered increased attention during the global financial crisis, has recently been spotted. For example, the Direxion Daily S&P Biotech Bear 3X Shares (NYSE:LABD) recently delivered returns well in excess of triple the daily inverse performance of the S&P Biotechnology Select Industry Index when measured over multiple weeks during the recent biotech calamity.

Of course, there are a litany of examples of leveraged ETFs, both bull and bear funds, underperforming their stated objectives, leaving a sour taste in traders' mouths. On this front, a frequent critique of leveraged ETFs has been the ill effects of daily rebalancing.

Leveraged ETFs: Short-Term Trading Vehicles

There are several reasons leveraged ETFs are always as advertised as short-term trading vehicles and one of the prime reasons is daily rebalancing. Leveraged ETFs invest in derivatives to attain leverage and those derivatives require daily rebalancing to bring the ETF in line with the index it is attempting to track.

Related Link: Bullish Leveraged Gold Miners ETFs Are On Fire

Daily rebalancing of leveraged ETFs has also been highlighted as contributing factor in end-of-day market volatility. However, data suggest that even with a recent uptick in end-of-day leveraged ETF rebalancing, daily rebalancing of these funds is well off the levels seen in 2011.

With the increase in volatility, speculation has resurfaced about the daily leveraged ETF rebalancing exacerbating end-of-day moves, a concern brought up in 2011 as well. However, we feel the impact has been relatively small in the context of the entire market similar to what we wrote in 2011, said Credit Suisse in a recent note.

Overall, daily leveraged equity ETF rebalancing has averaged only 0.5 percent of total value traded since August 20th. In terms of end-of-day liquidity (last 30 minutes), leveraged equity ETF rebalancing has averaged over 2 percent in the large cap space (compared to 1 percent the rest of 2015) and over 3 percent in the small cap space (compared to 2 percent) over the same period.

So with the increase in volatility starting in late August, ETFs such as the Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA) and the Direxion Small Cap Bull 3X Shares (NYSE:TNA) have perhaps seen increased daily balancing; however, that does not mean the same can be said of all leveraged ETFs. Nor does it mean market participants are at risk as a result.

Volatility Increases, But Leveraged ETFs Remain Steady

An interesting point is, as Credit Suisse noted, leveraged ETF assets have remained steady even as volatility has increased. In fact, some of this year's most popular new ETFs of any variety are leveraged funds, a group that includes the Direxion Daily S&P Biotech Bull 3X Shares (NYSE:LABU) and the Direxion Daily CSI 300 China A Share Bull 2X Shares (NYSE:CHAU).

While leveraged ETF rebalancing activity has increased, we have yet to experience the more extreme levels seen in 2008-2011 both in terms of absolute peaks as well as average highs.

The biggest source of the leveraged equity ETF rebalancing activity has been large cap funds. Compared to 2009 and 2011, leveraged equity ETF products in Financials, Real Estate, and Small Caps have not contributed as much to rebalancing, according to Credit Suisse.

Decreased Rebalancing For Leveraged ETFs

Volatility for leveraged ETFs such as TNA, TZA and the Direxion Daily Financial Bull 3X Shares (NYSE:FAS) has dwindled over the past four-plus years. In fact, leveraged ETF rebalancing is smaller percentage of end-of-day trading then it was several years ago.

Perhaps more importantly, rebalancing activity is still a smaller percentage of end-of-day trading than in the volatile periods experienced between 2009 to 2011. Since August 20th, large cap leveraged equity ETF rebalancing has averaged over 2 percent of total large cap trading in the last 30 minutes of the trading day. While a significant increase from the 2015 average (prior to August 20th), it is below the 3 percent average experienced in 2011, noted Credit Suisse.

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