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Hector McNeil, Boost ETP

Boost ETP comes out in defence of S&L ETFs

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Short and leveraged (S&L) exchange-traded product specialist Boost ETP has entered the debate started by Tugkan Tuzun’s paper published in July 2013 – Are Leveraged and Inverse ETFs the New Portfolio Insurers? 

 
Boost feels that there is need for more clarity and reasoned debate around the conclusions of Tuzun’s analysis.
 
Tuzun’s main conclusion is that the daily rebalance of S&L ETF which naturally occurs in the same direction in which the market is moving which could trigger a “cascade” reaction leading to a domino effect potentially causing market crashes. Tuzun provocatively titles his paper “Are Leveraged and Inverse ETFs the New Portfolio Insurers?” Boost says the comparison with “portfolio insurers” is clearly designed to grab attention rather than add anything to the analysis.
 
Boost feels that the view taken and the conclusions reached by Tuzun are simplistic in approach and ignores the basics of how markets work and the facts related to S&L ETFs.
 
First of all ETFs are essentially market access tools. They do not invent trading or investment strategies, but rather just give investors tools to use to express them. S&L ETFs also sit alongside many types of leveraged trading vehicles including prime brokerage accounts, futures, options, structured products, margin trading, OTC derivatives, CFDs/spread bets, covered warrants and so on. Interestingly the leverage factor employed by S&L ETFs is usually two or three times the return of the index. This is an extremely low leverage compared to the leverage employed by some of the instruments listed above which can be up to 20 times.
 
Secondly the global assets under management (AUM) of S&L ETFs is around USD50bn. This is inconsequential compared to the USD2 trillion of AUM in global ETFs, which is actually less than 10 per cent of global AUM in mutual funds. This is further diluted by the fact that S&L ETFs tend to only give access to the most liquid underlying markets, such as the FTSE 100, gold etc. and not across the broad range of illiquid exposures provided under the broader ETF and mutual funds markets. Some of these exposures can be less liquid than those tracked by S&L ETFs.
 
Thirdly Tuzun seems to claim that the end of day trading is a major contributory factor. Stock markets tend to see the majority of trading activity at the start and end of the day in a U curve shape. There is a huge amount of activity at the close and in the closing auctions on the various global exchanges. This is of course for a variety of investment and trading strategies. If anything, the close on an exchange is the point of the day when liquidity is highest and where leveraged ETF rebalancing is least likely to have an impact.
 
Finally, Tuzun fails to consider why some investors use S&L ETFs. Boost’s clients very often use S&L ETPs in order to hedge their existing positions. Therefore the likelihood is that if S&L ETFs were not available these investors may be forced to employ more capital in essentially the same way as S&L ETFs do, use other hedging tools which need to be similarly rebalanced, or liquidate positions short term in sharp market movements even though they would prefer to hold them for the longer term, which could in itself could contribute to a “cascade effect”.
 
Other researchers also disagree with Tuzun’s conclusions. William J Trainor (2010) concludes that leveraged ETFs do not appear to have any substantial effect on the market. Credit Suisse published a paper in 2011 titled “Leveraged ETF Rebalancing in Perspective” which concluded that “leveraged ETF rebalancing trades are unlikely to be the most influential factor in driving intraday swings into the close”. There has been no significant changes to the AUM or structure of S&L ETFs which would have changed these earlier conclusions.
 
Hector McNeil (pictured), co-chief executive of Boost, says: “We think the Tuzun paper is a headline grabber and doesn’t stand up to real world scrutiny. Given the size of the S&L ETF market globally and the strategies that investors employ when using them, we firmly believe the impact is minimal. S&L ETFs provide an important tool for investors to hedge their portfolios and protect their investment as well as an efficient way to gain exposure to a market and preserve valuable capital.
 
“When compared to other ways of gaining leverage or short exposure such as futures, options, CFDs, spread bets and structured products, S&L ETFs have some real benefits. Investors can’t lose more than their initial investment; they don’t need to complete complex derivative documentation; they trade on exchange with multiple market makers; and counter-party risk is managed through a robust and transparent collateral processes.”

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