Are Leveraged and Inverse ETFs the New Portfolio Insurers?

43 Pages Posted: 16 Oct 2013

See all articles by Tugkan Tuzun

Tugkan Tuzun

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: June 13, 2013

Abstract

This paper studies Leveraged and Inverse Exchange Traded Funds (LETFs) from a financial stability perspective. Mechanical positive-feedback rebalancing of LETFs resembles the portfolio insurance strategies, which contributed to the stock market crash of October 19, 1987 (Brady Report, 1988). I show that a 1% increase in broad stock-market indexes induces LETFs to originate rebalancing flows equivalent to $1.04 billion worth of stock. Price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks. Implied price impact calculations and empirical results suggest that they contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011 when the European sovereign debt crisis came to the forefront. Although LETFs are not as large as portfolio insurers of the 1980s and have not been proven to disrupt stock market activity, their large and concentrated trading could be destabilizing during periods of high volatility.

Keywords: ETFs, price impact, financial stability, stock market crashes

JEL Classification: G23, G14, G11

Suggested Citation

Tuzun, Tugkan, Are Leveraged and Inverse ETFs the New Portfolio Insurers? (June 13, 2013). FEDS Working Paper No. 2013-48, Available at SSRN: https://ssrn.com/abstract=2340616 or http://dx.doi.org/10.2139/ssrn.2340616

Tugkan Tuzun (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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