Leveraged exchange traded funds amplify index swings -Fed economist
WASHINGTON Aug 12 (Reuters) - Trading patterns by Leveraged Exchange Traded Funds increased volatility during the 2008-2009 financial crisis and are similar to portfolio insurance strategies that contributed to the 1987 stock market crash, according to a study by the Federal Reserve.
LETFs, a $20 billion-plus market in the United States, are exchange-traded products that generally promise to deliver a multiple of the daily change in an underlying stock index.
In a recent paper, Fed Board economist Tugkan Tuzun argued that the way LETFs rebalance their portfolios every day, by buying when the index rises or selling when it falls, can have a significant impact on underlying stock prices.
This is compounded by the predictability of LETFs trading behavior which others can anticipate, particularly in the final hour of the trading day, adding to volumes.
"The implied price impact of LETF re-balancing on financial markets was notable especially during the financial crisis of 2008-2009 and at the height of the European sovereign debt crisis," Tuzun said in the study, which does not reflect the views of the Fed as an institution.
Attention on automatic program trading has been high since the so-called Flash Crash of May, while computer-driven selling linked to portfolio insurance was held to blame for a large part of the Black Monday equity losses suffered on October 19, 1987.
"Although LETFs have not been proven to disrupt stock markets, 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," Tuzun wrote.
He also warned the habit of LETFs to do their rebalancing at the end of each day could inflict "disproportionate price changes" that might hurt the confidence of other investors.
"If the market closes with depressed prices, the stock market could experience large investor outflows overnight," he said.
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