Could ETF's Cause the Next Market Crash?

The exchange-traded funds (ETF) that use leverage to double and triple returns on stock market moves could cause the next big market crash, according to the Federal Reserve. In an article titled "Are Leveraged and Inverse ETFs the New Portfolio Insurers?" from the central bank stirred markets into wondering what would happen if the funds ever went haywire. The article asserts that the funds could act in the same way as the "portfolio insurance" that helped crash the market in 1987, writes Jeff Cox of CNBC.

"Although (leveraged ETFs) 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," study author Tugkan Tuzun wrote.

At the heart of the problem is the way the leveraged ETFs work. The ETFs provide both bullish and bearish investors with two and three times the market's respective gain or loss during a session, then rebalance at the end of each trading day.

Tuzun writes:

"The implied price impact estimates of LETFs on broad stock-market indexes become significant during periods of high volatility, especially for the stocks of financial terms. LETF rebalancing in response to a large market move could amplify the move and force them to further rebalance which may trigger a "cascade" reaction. Rebalancing in the last hour of trading could, in fact, reduce the possibility of a price dislocation since the market close could serve as a prolonged circuit breaker. On the other hand, executing orders within a short period of time, such as the last hour of trading, may cause disproportionate price changes. A significant price reduction at market close may also impair investor confidence. If the market closes with depressed prices, the stock market could experience large investor outflows overnight."

The ETFs in question have taken in about $3.3 billion in funding in 2013, which pales compared with the $177 billion in new money to the $1.53 trillion space.

It's worth noting that the products as a group are down 44 percent in return for the year.

The Fed's warnings are at least useful in a market with rising volatility and potential dislocations.

If you have sustained investment losses due to your stock broker or financial advisor’s recommendations regarding ETFs, call Soreide Law Group for a free consultation on how to potentially recover your losses. To speak with an attorney call 888-760-6552.