It's probably part of a hedge, possibly even some 1987-style portfolio insurance (the more a position goes down the more you hedge until you descend into a self-sustaining vortex of doom)...I like that "vortex of doom", more below.
Leveraged ETFs, the Flash Crash, and 1987
Okay, this is going to be a wonky post. But it brings together a high-risk investing strategy, the flash crash, and the Crash of 1987, and shows how little-known corners of the investing world can still have a big market impact.HT: The Reformed Broker
You could be forgiven if you’ve never heard of leveraged ETFs. But this smallish corner of the investing universe could, under the right circumstances, do to the market what portfolio insurance did to the market in 1987: that is, force a liquidation that sparks a big selloff.
At least, that’s the suggestion of a new paper from the Federal Reserve Board, written by staffer Tugkan Tuzun. He likens leveraged ETFs to the portfolio insurance schemes of the 1980s, which are believed to have either contributed to or even caused the great crash of October 1987, when the Dow Jones Industrial Average dropped 22% in one day.
Portfolio insurance was a popular hedging strategy in the ’80s that used options, and “synthetic options,” to protect against losses. But it involved a daily rebalancing that, in October 1987, led to a “cascade” of sell orders that exacerbated what happened on Oct. 19, 1987.
That kind of one-day drop would be much harder to produce today, given the circuit breakers that were installed specifically in response to the ’87 crash. But the point of the Fed paper is that leveraged ETFs could, under the right conditions, produce a similar cascade of sell orders, amplifying the severity of any market drop.
Leveraged ETFs date back only to 2006, and have only about $20 billion in total assets. The key here, though, is what’s called rebalancing, which these funds typically do on a daily basis. Because these funds promise a certain multiple over the underlying exchange it’s tracking, the funds use derivatives and borrowed money to amplify their returns. Also, to maintain those returns, the fund managers must buy when the market is going up, and sell when it’s going down.
That’s where the 1987 connection comes in. What is generally believed to have happened in 1987 – it is still a debated subject – was that once the selling started, the portfolio insurance strategies demanded investors sell, resulting in a massive wave of sell orders....MORE
The Financial Times looked at a slightly different problem back in June when the dynamic rebalancing wasn't quite dynamic enough:
FT: "ETF Losses Today Were Far Beyond What The Most Sophisticated Risk Models Could Have Predicated" (BLK):
There was a time when portfolio insurance guaranteed that events like Black Monday would never happen. Then Black Monday happened precisely due to portfolio insurance. Some years later, the credit-driven housing boom made modeling of declining home prices at rating agencies (and everywhere else) redundant.Or, from September 16, 2008:
Then the (first) housing and credit bubble popped leading to the biggest housing market crash in US history. Fast forward to today, when ETFs were supposed to be the "greatest thing since sliced bread" and providing an ultra-low cost alternative to mutual fund and other market exposure "for the people", were supposed to revolutionize investing.
Until days like yesterday. To wit from the FT: "The losses for ETFs today were far beyond what the most sophisticated financial risk models could have predicated for worst-case scenarios," said Bryce James, president of Smart Portfolio, which provides ETF asset allocation models....
Just remember, "The only perfect hedge is at Sissinghurst":