First in response to Herb's tweet, I do not think he is an idiot (no idea if that tweet was directed at me or not).
Let me clear that I do believe certain ETFs are having some sort of influence on markets in an unintended consequence sort of way but that it is not the magnitude of problem that some think and more specifically I contend that we do yet fully understand this issue. I don't believe the effect is as powerful as some believe but time may prove me wrong. In the mean time we are still trying to figure it out and if anyone has actually figured it out yet, they are not telling anyone.
The focus of the article is 2x and 3x ETFs with the first point cited by Herb that they "create an artificial market for the stocks they own." Keep in mind the report is from an energy analyst not an ETF analyst. So the first thing is the 2x and 3x don't own any stocks they own derivatives. In the course of trading these ETFs there is hedging that might go on to fill a kind of large order and that might make its way to a some of the larger stocks eventually (domino effect) but the more direct cause and effect would come from creations and redemptions where shares are created by buying derivatives which is actually more like increasing open interest in futures or creating OTC swaps. Again the hedging here by whoever is providing the exposure might make its way to stock trading, I say might.
Average volume in DIG, one of the funds mentioned, is 1.8 million shares and the market cap is $295 million. The average dollar volume for DIG is around $80 million. The DUG ETF (double short energy stocks versus DIG's double long) has average dollar volume of $60 million. It might be too simplistic to say that this nets out to $20 million per day but there is some offset and it may not be too simplistic for there to be a one for one offset. Whatever the net effect, I contend it is not enough to have the impact on the entire sector as claimed by the Bodino report. On an intuitive basis this simply is not big enough to be the only answer and it might not even be a meaningful contribution to the increased correlation cited.
There is also mention of the extent to which investors, by way of trading ETFs, are trading in stocks they would otherwise never own. Taking an example from the article, no one thinks about Parker Drilling when they buy an energy stock ETF but the ETF trading is creating volume in the stock that wouldn't otherwise exist, so says the report. As mentioned above, this is not a universally correct idea. There might be more volume but there does not have to be.
"However, when investors buy and sell long and short ETFs on the open market, they are transferring money to long and short ETFs to purchase or sell short certain securities which in turn create a self-fulfilling prophecy across the industry as the money flows move in and out of the underlying securities."
Again, the vast majority of the time this will only apply to creations and redemptions which are usually 25,000 share trades or 50,000 share trades.
Also in reference to this point, anyone remember buy programs? Before ETFs there were baskets of actual stocks purchased, which is a direct increase in volume. Twenty years ago this might have meant buying a basket of energy stocks to reflect the XOI index. I realize buy programs also means trading SPUZ futures based discounts and premiums to fair value.
Herb also references the report's number crunching on increased correlation in the energy sector which is also tied to levered ETFs. This overlooks the extent to which the correlations of foreign markets to the US has gone up in recent years.
Yes there are 2x and 3x country funds but the volume is miniscule. Of the single country funds I only found two from ProShares with volume more than 100,000 shares; ProShares Ultra Short China (FXP) and ProShares Ultra Short Brazil (BZQ). From Direxion there was just the Daily China Bull 3x (YINN), but there were a couple of others close to 100,000 shares.
Correlations to all sorts of things are up but circling back to the theme of this post the ETF explanation simply does not fully account for what has happened.
Herb might be correct that 2x and 3x funds should be shuttered (not my base case) but the argument put forth by Bodino and echoed by Herb does not go anywhere fully accounting for what has really happened and again I contend we as an industry do not yet know the entire story and if we eliminate these funds tomorrow it will not hasten a return to normalcy.