US Federal Reserve defends “casino on steroids” ETFs

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Leveraged exchange-traded funds (ETFs) may have been slammed by Blackrock CEO Larry Fink as having “structural problems that can blow up the whole industry,” but their risks are overstated, according to new research by the US Federal Reserve.

In a report entitled Are Concerns About Leveraged ETFs Overblown? Federal Reserve economists Ivan T. Ivanov and Stephen L. Lenkey acknowledge widespread concerns over the derivative-backed investment vehicles, but say that criticisms “are likely exaggerated because they ignore the effects of capital flows on ETF rebalancing demand.” When dealing with large scale returns, claim the researchers, capital flows “substantially reduce the need for ETFs to rebalance,” limiting the amount of volatility that ETFs can create.

ETFs work by using derivatives and debt to amplify the returns of an underlying index. Depending on the ratio used for the investment time frame, the fund may return twice or even three times the percentage returned by the index, before management fees or transaction costs are subtracted.

The reason they are deemed so dangerous is that the amplification works both ways – so, if the index falls by 1%, an ETF with a 2:1 ratio will actually lose 2%. Added to this is the fact that ETFs follow daily, rather than yearly changes, meaning that fluctuations are exaggerated and could spark panic among investors as their losses accelerate, destabilising markets in turn.

While this latest Fed-commissioned research seeks to show (both empirically and theoretically) that ETFs may not quite have the potential to cause chaos that has widely been presumed, its lukewarm endorsement seems unlikely to win over detractors, who have vehemently warned against using ETFs.

Critics such as the veteran investor and Seabreeze Partners chief Douglas A. Kass have gone as far as  to describe the funds as “new weapons of mass destruction” that turn the market into “a casino on steroids.”