Wednesday, October 12, 2011

Doug Kass on ETF's Driving Late Day Volatility (and a response)

I usually don't have much time for Mr. Kass, the thinking being that anyone who is as much of a publicity hound as he is can't be spending much time running the Seabreeze Fund.
Plus his performance is no great shakes which is at variance to some of his public pronouncements, which have been fairly timely over the last few months. That type of divergence spooks me.
That said, I thought there might be something to his hypothesis on ETF rebalancing.
From the New York Times' DealBook:
Did you watch the markets on Monday? In the last 18 minutes of trading, the Standard & Poor’s 500-stock index jumped more than 10 points with no news to account for the rally. If you were left scratching your head, you were not alone.

Almost every day there is an article in the newspaper trying to explain the stock market’s wild swings, or volatility, and often the explanation is inconclusive, involving everything from Europe’s banking problems to new fears of recessions.

Through the summer and into the fall, I, too, have been pondering the gyrations in trading, especially the late-day sell-offs and rallies that seem always timed perfectly to coincide with the closing bell. Rarely do the rallies or sell-offs, which invariably start after 3 p.m., justify 3 to 4 percent moves in the indexes. The swings have a deleterious effect on the markets because they undermine confidence and investors start sitting on the sidelines.

And then I started talking with investors like Douglas A. Kass, a longtime Wall Street denizen who is the founder and president of Seabreeze Partners Management.

He says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or E.T.F.’s.
These funds, which allow investors to bet on a certain basket of stocks, commodities or an index, are perhaps the hottest rage in investing, with some $1 trillion invested. E.T.F.’s are particularly attractive to some investors because you can bet long or short — and you can leverage your bet. And you can hop in and out within the trading day to lock in gains, just as with stocks.

If you bet $100 that the ProShares Ultra S&P500 would rise by 1 percent on a given day, and it did so, say by 3 p.m., you could settle the bet and receive double the return — in this case 2 percent (excluding fees). Of course, if the market goes in the opposite direction, you could lose 2 percent. There are also what are called inverse leveraged E.T.F.’s that go up when the price of the basket of goods goes down, and vice versa....MORE
Doing the PointCounterpoint Schtick is Benzinga:
A Retort to Andrew Ross Sorkin on ETFs
In a late night post on New York Times Dealbook, Andrew Ross Sorkin, wrote a post talking about the "evilness" of ETFs. Sorkin interviewed Doug Kass, of Seabreeze Partners Management and other hedge fund managers about leveraged ETFs, and the supposed volatility they have caused in recent weeks and months, especially towards the end of the trading day. He also drummed up some white papers both for, and against ETFs and how they play a role in market volatility.

Mr. Sorkin interviewed Kass, and Kass said, “They've have turned the market into a casino on steroids. They accentuate the moves in every direction — the upside and the downside.” Kass has written about this subject extensively on

The founder of DealBook, a blog purchased by the New York Times (NYSE: NYT), also got details from others in a white paper on the topic. The paper was penned by Harold Bradley and Robert E. Litan of the Kauffman Foundation, and they wrote, “It is these derivatives and not the phenomenon known as high-frequency trading (H.F.T.) — commonly critiqued as contributing to the ‘flash crash' of May 6, 2010 — that pose serious threats to market stability in the future. The S.E.C., the Fed and other members of the new Financial Stability Oversight Council, other policy makers, investors and the media should pay far more attention to the proliferation of E.T.F.'s and derivatives of E.T.F.'s.”

Sorkin also notes that Barclays Global's research department did a study before the flash crash in May 2010. Barclay's seems the same thing, that these leveraged ETFs create systemic risk due to the leverage and ability to “amplify the market impact of all flows, irrespective of source.”

On the other side, Sorkin quoted a report from William J. Trainor Jr., a professor at East Tennessee State University, who said that market volatility has nothing to do with the ETF re-balancing. “Intra-daily volatility in time periods not associated with rebalancing saw the same spikes in volatility as the last 30 minutes did,” Trainor Jr. wrote.

This is definitely a controversial topic, but you have to take into account that we are living in extremely volatile times right now. These products were around before the financial crisis started (some say it started late in 2007, others say in the summer of 2008). The moves up and down at the end of the days were not nearly as high and dramatic, or as frequent, as they are now.

The volatility or fear index, as measured by the CBOE Volatility Index (VIX), is over 33, and has remained over 30 since the beginning of August, when the American debt issues and worries about Greece really started to reemerge in the market place. Since then, the U.S. has lost its AAA rating from S&P, and almost defaulted on its debt. The worries about Greece also popped up where it looked like it may actually default. Look at this chart showcasing the VIX over the past year. We did not see outsized moves at the beginning or end of the day while the VIX was in the mid teen's. It was a fairly benign market....MORE