The ETF market is pushing the limits of the leverage it can handle

Next week, several exchange-traded fund companies plan to launch with the latest ETFs that offer a way to add leverage to bets on single stocks, in this case the South Korean chip giant. SK HynixIt began trading in the US on Friday.

This development should come as no surprise: Similar SK Hynix portfolios are already among the most popular ETF transactions in the South Korean market. And there’s nothing inherently wrong with SK Hynix ETFs scheduled to come to the US from the following companies: Granite Shares And ProShares. Demand for the stock, which is off the radar of most U.S. investors because it is not listed domestically, is “tremendous,” the company’s president told CNBC.

Most existing single-stock ETFs traded in the largest tech companies in the U.S. operate as normal each day, covering all of the Magnificent 7 tech companies, from Nvidia to Apple and Tesla. SpaceXThis is not unusual for a new issue, which fell below its open price on its first trading day earlier this week and is down nearly 8% since its IPO.

As long as investors understand the risks involved in using leverage, ETFs will continue to be launched because the demand for such transactions will continue to grow. But for an ETF market that has been booming for more than three decades with low-cost, tax-efficient, core index fund investments that cover broad markets like the S&P 500, the launch of yet another leveraged ETF is a sign of an industry shifting dramatically to deliver returns for investors, and ETF experts say fund sponsors, investors and regulators need to pay more attention.

Leverage in the ETF market is “getting a little carried away,” according to ETF Action co-founder Mike Akins.

“It’s not like the products are bad,” Akins said on this week’s “ETF Edge.”

“A lot of ETFs coming into the market do what they say they’re going to do, whether it’s 2x the memory stock or vice versa. But sometimes what they say they’re going to do isn’t very good for the overall ecosystem of the market. There were some things that shouldn’t be in a regulated product,” he added.

Alex Morris, CEO and CIO of F/M Investments, says there were many interesting ideas that the ETF company decided not to bring to market due to limited liquidity, leverage and options use, and concerns that it would be difficult to properly communicate risks to investors. “Sometimes what investors want has to be in a different format. If you really want a lot of leverage, the futures market is probably the place for you, and the options market is where you can get not just 2x, 3x, but 10x to 100x,” he said.

But Morris added that there is a compelling reason why most of these transactions occur in the ETF wrapper. The amount of paperwork and disclosures related to leverage in the futures and options markets are much more burdensome for investors than ETF trading.

Akins said the goal of ETFs is to make trading easier, whether it’s 500 stocks around the world, 25 companies or a single company. “For the average investor, if I want 2x leverage on a stock that I think will post big gains, an ETF is a safer way to do that than a margin account,” he said.

Investors bear some responsibility, Morris said, and the biggest mistake investors make is having the mindset of “just wanting to grow a guaranteed return.”

Investors also need to understand how single-stock ETFs work as trading vehicles, especially how losses can accumulate quickly. “With traditional leverage you get margin calls. But when you have a long position of only 2x a name you can get a NAV [net asset value] If you buy it and don’t pay attention it gets close to zero. You can find a stock, but [your] The position is clearly below. This is an education issue,” Morris said.

“Single stocks are the obvious example where the situation can get out of control very quickly,” Akins said.

“The market can only handle so much leverage, and if more leverage builds up there, there has to be an inflection point. I think there’s probably an inflection point in certain types of ETFs, in stocks that are trying to get into leveraged packages,” he said.

Market makers and brokers who provide leverage and risk will step back, Akins said, adding that if you look at some of the larger products in the market right now, “we’re starting to see that.”

Both the cost of obtaining the leverage and the risk to the counterparty of the leverage “have become very extreme,” he said. “The market may decline to a certain degree, but regulators have a responsibility to not create a scenario where there are no checks and balances to prevent the market from becoming too leveraged,” Akins said.

When there are five, six or even a dozen ETFs all doing the same thing, and investors all want to be on the same side of the trade and there aren’t many sides to trade against, “that’s where the destabilizing factor starts to come into play,” Morris said.

Securities and Exchange Commission announced On June 30, a request was made for a new comment period on ETF innovation and “new investment strategies”; Many expect the focus not to be on single-stock ETFs but on another emerging area of ​​the market that uses derivatives: prediction markets ETFs.

Morris said on this week’s podcast episode of “ETF Edge” that more investment concepts introduced in the ETF suite could benefit many investors through asset scale reducing trading costs and complexity, but the questions the SEC is starting to ask are the right questions. “How did we get here? … What is the right way to deal with an industry that has expanded from passive, low-cost, tax-efficient products to a broad range of products and new products that use tools of speculation that did not legally exist five years ago, let alone 30 years ago?”

“The SEC has a duty to say: ‘When will this be over? What’s the next interesting thing we can invent?'”

And the market won’t stop answering that question without causing potential harm to investors. “The market will continue until something happens,” Morris said. “And the SEC’s job is to say: ‘How can we stop this from being a bad thing and undo the 35-plus year history of great financial success?’

Morris emphasized that he does not believe ETFs will be the cause of a systemic event in the market, but added that when it comes to the forces that could end the current boom in riskier ETFs, “the next external market event that is not ETF specific will help us find that out pretty quickly.”

Right now “it’s hard to stop that train and [the market] “You don’t necessarily have to try it,” he said. “We’ll definitely see more leveraged one-this, one-that products. They became so successful that people could not stop. Raw capital says they should keep going, and they will,” Morris said.

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