There’s logic in thinking that trading in funds that promise double or triple the movement of the market will exacerbate the swings that occur. But it would invert reality.

There’s fundamental logic in worrying about the “cascade effect” that can cause markets to swing wildly.

The poster day for this effect of course is May 6, 2010, when $4 billion of orders placed by a Midwestern mutual fund complex officially triggered a Flash Crash. In one 15-minute period, the Dow Jones Industrial Average dropped more than 600 points. And snapped back.

Now come exchange-traded funds, raising fears that they could trigger more market instability.

Exchange-traded funds of all types now account for 32% of daily volume in terms of the notional value of trades, according to NYSE Euronext. But concern centers on two categories of the funds, which can be bought and sold throughout a stock trading session.

Those types are so-called “inverse” funds, which guarantee they will move in apposition to the basic movement of an underlying market, and leveraged funds, which promise double or triple the movement of the market in a given direction.

The problem here, as explored in Wednesday’s Capital Markets Consoritum breakfast at Bayard’s in Hanover Square, is that these funds have to square up their accounts on a rolling basis to meet their promises.

Which in turn means, they’ll get particularly active at the end of a trading day. Which, in theory, could push markets further than base investor sentiment and activity would naturally take it. And create instability.

But, contends Stephen Cook, chief operating officer of BNY Mellon Asset Servicing leveraged and inverse ETFS “make up less than 10 percent of trading in the last 10 minutes of the NYSE.’’

That won’t push markets one way or another, he said.

There is “no correlation “and I highly doubt there will be” one ever proven by studies, which so far have not shown any conclusive correlation.

The NYSE sounds more skeptical on this.

Thomas Champion, senior director, global indexes and the exchange-traded products group at NYSE Euronext, said that, on a typical day, only about 4% of the volume at the end of a day is trading in leveraged or inverse ETFs.

In looking at the question, “what we discovered is there is no impact,” he said.

Big moves at the end of a trading session could most often be attributed to “macro events” – read: events involving sovereign debt on both sides of the Atlantic and such – and not ETFs.

Looking back to the Flash Crash in May 2010, a case has been made, he noted, that ETFs may have contributed to the plunge of prices. Roughly 200 exchange-traded funds saw their share prices, for instance, drop to prices under a dollar and as low as 1 penny.

But that was because ETFs are based on selections of stocks, in indices they track. And if Procter & Gamble or Accenture go down to 1 penny a share, the pricing models of ETF market makers break down.

“What we witnessed that day” was that those market makers, Champion said, couldn’t price the basket of stocks they were tracking, so they got out of the market.

 “ETFs were actually a victim of what happened that day,’’ he said. “And had nothing to do with its cause.”

Tom Steinert-Threlkeld writes for Securities Technology Monitor.



Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access