Market Impact of ETFs and Futures

The ultra varieties, which are leveraged versions of the basic ETFs, will also use stocks and swaps to obtain their desired return. The Ultra S&P 500 ProShares (SSO - commentary - Cramer's Take) uses stocks, while the UltraShort S&P 500 ProShares (SDS - commentary - Cramer's Take) uses a combination of both. In order to obtain a properly indexed ultra position, the swaps have to be dynamically managed so as to generate the leveraged gearing that the ETF purports to deliver.

Most recently, we have witnessed the introduction of the 3x ETFs, including the Direxion Shares ETF Trust Large Cap Bull 3x (BGU - commentary - Cramer's Take) and Direxion Shares ETF Trust Large Cap Bear 3x (BGZ - commentary - Cramer's Take), which triple the long or short exposure to an index or portfolio. According to the SEC filing for these 3x funds:

Each Bull and Bear Fund invests significantly in swap agreements, forward contracts, reverse repurchase agreements, options, including futures contracts, options on futures contracts and financial instruments such as options on securities and stock indices options, and caps, floors and collars.

Trading Activity

Many intelligent professionals on this site and elsewhere hypothesize that ETF activity -- and, in particular, the ultra or 3x funds -- is largely responsible for the huge market volatility that we are currently experiencing. I decided to take a look at one day's activity to analyze the massive amount of dollar volume that is taking place to see if we can ascertain a causal relationship between ETFs, futures and the market indices.

For Tuesday, Nov. 25, 2008, the S&P 500 moved in a range between $834.99 and $868.94 and closed higher on the day by 0.66%. The following table estimates the dollar equivalent value of the exchange's ETFs and emini futures (after accounting for the security or contract leverage) traded that day based on my research and calculations:

It is clear that there is a huge amount of money being thrown around, but the overwhelming preponderance of traded equivalent value takes place in the futures pits, which seem to dwarf the ETF dollar equivalent volumes. (Note: Excluded from my table above are related instruments that also need to be factored in such as index options, both exchange traded and OTC, and swaps. Swaps and OTC options data are not available given the current lack of regulation and a central clearing system. Listed options trades are available, but the analysis would have been far too complex for this brief article. In the end, based on my quick scan, options turn out not to be a big factor, and my conclusion that futures are responsible for most of the current index volatility still stands.)

I would say that it is a reach to conclude that index ETFs alone (levered or unlevered) are the tail wagging this doggy market. On the other hand, futures appear to have a much larger footprint on the activity of speculators and hedgers. Clearly, ETF activity can spill over to futures and/or stocks as market participants seek to offload or hedge risk. The causal flow may also be reversed as futures participants use ETFs and/or stocks to hedge or offset risk. The data suggests that ETF activity is only a fraction of futures activity, however, and thus we should look to the futures pits for indication of market volatility and manipulation.

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At the time of publication, Rothbort was long the Ultra S&P 500 ProShares and Ultra Financials ProShares, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.