LETFs (leveraged exchange traded funds) may contribute to stock volatility in the same way that portfolio insurance contributed to the 1987 stock market crash, according to recent research done by Tugkan Tuzun at the U.S. Federal Reserve. He argues that the same positive feedback loops, especially during the final hour of trading, exacerbate high volatility, though it may not have a significant effect on the market during times of relative stability.

Fed: LETFs Contribute To Stock Volatility

Before the stock market crash of October 19, 1987 asset managers often used portfolio insurance strategies that involved buying stocks when the market moved up and selling when the market fell. The goal of these strategies is to preserve beta and the fund’s long-term value, while the manager looks for growth opportunities.

Selling in anticipation of “insurance trades” creates a loop

The problem was that, being such a predictable strategy, “aggressive-oriented institutions sold in anticipation of the portfolio insurance trades,” Tuzun writes. “This selling, in turn, stimulated further reactive selling by portfolio insurers. Price-insensitive and predictable trading of portfolio insurers contributed to the price decline of 29 percent in S&P 500 futures through a selling cascade.”

After the ’87 crash, most asset managers moved away from portfolio insurance strategies, and once usage drops below a critical mass it no longer has enough sway to create these trading cascades.

Anticipating the LETF’s which are anticipating the market …

LETFs are more complex than portfolio insurance, but the bottom line is that they trade in the same direction as the market. At the end of each day, these funds calculate what trades need to be made in order to preserve their stock-to-cash ratios, and then make trades accordingly.

As LETFs have grown in popularity, their impact on markets has grown as well. While they follow different indices, the bulk effect of the daily rebalancing can be as much as a few percent of total daily volume for some stocks. For trading that is so predictable, that’s enough that opportunistic traders may want to get in before the rebalancing for some easy arbitrage.

This is where the cascade effect kicks in. If the market moves sharply down, and everyone knows that the LETFs are going to sell in response, traders who are trying to take advantage of the funds will artificially drive the stocks even lower, causing a greater response from the LETFs. This positive feedback, right at the end of the day, can have a further psychological impact on investors and undermine confidence in the market, causing people to sell out in a panic because they aren’t aware of the underlying, somewhat mechanical nature of the dip.

“Although LETFs have not been proven to disrupt stock markets,” writes Tuzun, “it is plausible that during periods of high volatility, their impact in response to a large market move could reach a tipping point for a cascade reaction.”

H/T Zero Hedge