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 Quote) uses stocks, while the UltraShort S&P 500 ProShares (SDS Quote) 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 Quote) and Direxion Shares ETF Trust Large Cap Bear 3x (BGZ Quote), 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:

Symbol Description Dollar equivalent of trades Leveraged Long or short Type SPY SPDRs 38.75 billion No Long ETF SH Short S&P 500 ProShares 0.23 billion No Short ETF SSO Ultra S&P 500 ProShares 5.29 billion 2x Long ETF SDS UltraShort S&P 500 ProShares 14.14 billion 2x Short ETF Dec SPX Emini future 132.5 billion 50x Long Future Source: LakeView Asset Management, LLC

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.