In recent years, the exchange-traded fund (ETF) market has expanded significantly, offering a wide array of strategies, including volatility selling, options structures, leveraged long, short selling, and more recently, leveraged exposure to Bitcoin. These ETFs have pre-written trading rules to allocate capital based on market volatility, direction, momentum, etc. Alongside ETFs, there are other investment vehicles like Commodity Trading Advisor (CTA) funds, volatility-controlled funds, smart beta products and bank-provided quantitative investment strategies (QIS). These are collectively referred to as rule-based or quantitative investments.
Growth in rule-based strategies comes amid a shift in the asset management landscape with the rise of passive investments. Rule-based strategies offer asset managers an opportunity to innovate and generate additional fee income, increasing their prevalence and reshaping market dynamics.
Volatility-selling ETFs, such as those focused on covered call strategies, reduce market volatility. These ETFs generate income by selling call options to dealers. Dealers, in turn, hedge their long option positions by buying as markets decline and selling as they rise, stabilizing prices and suppressing volatility. For example, currently, if you sell $25 billion notional of S&P 500 Index, December 31 6055 call options, we would expect banks’ hedging activities to help pin the index around the 6055 level until its maturity on December 31.
In contrast, leveraged ETFs can amplify market volatility. Their structure requires them to buy more in rising markets and sell more in falling ones, often at the market close, amplifying price swings. For instance, in 2022, significant inflows into leveraged short ETFs likely helped accelerate market selloffs.1
Similarly, during the yen carry trade unwinding in August 2024, outflows from the WisdomTree Japan Hedged Equity Fund (a yen-hedged ETF) likely amplified the Japanese market downturns.2
Although these rule-based investing strategies can depress or amplify market volatility, money flows into/out of these funds, and the equity allocation in volatility control funds and CTAs are highly momentum-driven.
In 2022, there were large inflows into short selling and leveraged short ETFs during the market downturn. We also witnessed an increased popularity of buffer ETFs, which have more downside protection. During the bull market of 2024, leveraged long funds are attracting large inflows, as shown in today’s Chart of the Week. These funds were designed to amplify returns in a rising market. Single stock leveraged long ETFs also grew from 18 stocks in 2022 to 65 today.3
This behavior of chasing the best-performing ETFs extends market trends — quiet markets become quieter, while volatile markets grow more chaotic. Historically, active managers provided a counterbalance to such momentum, but their diminished role in the era of passive management has reduced this balancing effect.
Key Takeaway
The innovation in ETFs is giving retail investors a new set of tools. The adoption of these ETFs has been fast, and the fund flows have in general followed the performance of the last six to 18 months. The result is a self-reinforcing cycle: strong markets grow stronger, while weak markets may face more pressure.
Sources:
1Track in Sight – ETFs Charted - Leverage & Inverse ETFs Across the Atlantic; 8/1/24
2The Japan Times – Yen-hedged ETF suffers exodus of cash from carry-trade fiasco; 8/13/24
3Nomura Securities Equities Derivatives; December 2024
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