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Fed Research Finds Little Worry in Leveraged ETFs

Recent research released by the Federal Reserve Board finds that leveraged ETFs pose much less of a volatility concern than previously thought. Critics were concerned that leveraged ETFs would add upward price pressure in upswings with additional purchases associated with rebalancing and downward pressure in downswings with additional selling. However, the authors argue that this view ignores the effect of capital flows, which add a mitigating effect. Though the authors acknowledge that flows could theoretically dampen or multiply the volatility effect of the ETFs based on the flow direction, they find that the empirical evidence demonstrates that the flows minimize the potential for amplification. The study focused on large, equity-based ETFs and found that “capital flows occur frequently and tend to offset the need for ETFs to rebalance their portfolios,” an effect that was particularly strong in times “when returns are large in magnitude, which is important because ETFs would presumably be most prone to amplify market movements in these cases.” The authors estimate that “returns generate up to 74% less rebalancing by leveraged and inverse ETFs once capital flows are taken into account.” Further, the researchers found that the effect was even greater with increases in leverage ratios.