Wall Street Journal: Are ETFs Driving Late-Day Turns?

We've been talking for many months about the new dominance of ETFs and the intense volatility, especially in the last hour in our national casino. The Wall Street Journal chimed in yesterday... and anyone who has hopes that the SEC does any investigating into these things need only look at the Ponzi scheme named Madoff. If they are missing things that are so abruptly in your face, do you think they are catching all the sophisticated games the quant funds can do to this market -who do you think is the smarter animal? I don't profess to know "what" is causing it; I just wish I had the faith to believe someone competent was actually looking into all the reindeer games going on behind the scenes.

• Many traders are blaming high-octane exchange-traded funds for the market's wild moves in the last hour of trading. They're called "leveraged" ETFs and are designed to magnify bets on broad stock indexes or more narrow sectors of the market, such as financials or real-estate investments.
• The final hour of trading has become significantly more active. In November, an average 26.2% of trading volume in the stocks in the Standard & Poor's 500-stock index took place in the final hour and 17.1% in the last 30 minutes, according to data from Credit Suisse. That's a much higher share than before: In 2006 and 2007, 20.7% occurred in the last hour and 12.9% in the last half hour.
• In many days, prices have been moving three or four percentage points in the last hour -- moves that not very long ago would have been extreme for an entire day.
• Certainly, the market's volatility has its roots in the financial crisis, tremendous uncertainty about corporate earnings and an economy in recession. But market swings have been magnified in the last hour of trading, from 3 p.m. to 4 p.m. in New York, and one explanation lies in these ETFs.
• On many days, leveraged ETFs are now some of the most actively traded securities in the stock market. They're popular among hedge funds and institutions as easy ways to make an aggressive, outright play on stocks or hedge a portfolio against unwanted market moves. But they have also become popular among fast-trading pros who piggyback on the ETFs as a way to make a quick profit in the final hour of the day.
• Bigger influences in the huge last-hour moves, some say, is selling due to redemptions in large mutual funds and hedge funds, plus a general unwillingness of market-makers and other traders to keep positions or orders open overnight.
• Leveraged ETF trading has exploded. Over the last three months, average daily trading volume in the UltraShort Financials ProShares -- which bets against financial stocks -- was 27 million shares, up from about 8 million in 2008's first three months. On Friday, 32 million shares of the UltraShort Financials ETF changed hands, compared with 24 million shares of Wal-Mart Stores Inc.
• But even with that kind of volume, how could these ETFs drive a market where billions of shares change hands every day? The answer, many say, has to do with the hedging by dealers who make markets in the funds and traders who pile on to make a profit. Unlike traditional ETFs, which are backed by baskets of individual stocks, leveraged ETF shares are usually created by using swaps or options. Brokers who sell the sponsors these funds must then either buy or sell the underlying shares covered by the ETF at the end of the day. And just as they magnify returns for investors, the amounts needed to hedge are multiplied.

Here is a sample example of how ETFs have blown the volume door off the underlying stocks they hold

• One example of a big ETF-inspired price swing came Dec. 1, when Conifer partner Robin Poore noticed an unusual volume spike in shares of Equity Residential, a real-estate investment trust owned by Conifer's money management unit. Equity is covered by both Proshares Ultra Real Estate long and Ultra Real Estate short ETFs. On that day, shares of Equity Residential fell to $23.85 from $29.83, with more than five million of its total 10.6 million in volume that day coming between 3 p.m. and 4 p.m. Prior to this fall, Equity Residential's daily volume rarely rose above five million shares. According to calculations by Mr. O'Rourke at BTIG, trading on Dec. 1 in the ProShares leverages short fund equaled 52% of the volume in Equity Residential shares. It's a similar story for many financials.

What some of these instruments are doing are changing the structure of the market; but the 'innovations' seem to have surpassed the ability of the regulators to monitor such innovation.

Wait... wasn't that, in a broader sense and in other markets, how we got in this whole mess?

Ah well, it's all just a horse racing track at this point.... they will come around to addressing this when legions of investors abandon the market saying nothing makes sense anymore. That would be par for the course, address the fire after everything has burnt down except for the ivory tower the regulator resides in. Until then, I love the #4 horse in the 3rd race....