Leveraged ETFs Pour Gasoline on the Volatility Fires

"And I've been putting out fire
With gasoline"
-- "Cat People (Putting Out Fire)," by David Bowie

I don't imagine that Bowie achieved much with that strategy, except for stretching the flames higher with every attempt.

And yet, this goes on all day, every day in the financial markets. If regular trading algorithms weren't enough, exchange-traded funds are putting even more fuel on the fires of volatility.

What is an ETF, anyway?
ETFs provide a happy medium between buying mutual funds and collecting every stock in whatever index you're trying to track. For example, you can't really invest in the Dow Jones Industrial Average (INDEX: ^DJI) index directly, unless you want to buy all 30 individual stocks yourself. But the popular SPDR Dow Jones Industrial Average ETF (NYS: DIA) sticks very close to the Dow over time.

That's because the structure of ETFs generally helps keep prices pretty close to the value of the market they track. With ETF shares, institutional investors known as authorized participants can keep close tabs on supply and demand of the publicly traded shares. If market interest suddenly waxes or wanes, that creates an arbitrage opportunity for those institutions, which can generally go to the ETF manager and either flood the market with newly created shares or tighten up the supply by returning shares to the ETF manager. Like Lumbergh in Office Space, simply ending Milton's paychecks rather than actually firing him, "it'll just work itself out naturally."

Most of the time, this works very well. Investors get low-cost, convenient access to investment vehicles that would be very difficult to emulate on our own. You can even sell ETF shares short or trade options on top of them. Institutions regularly reap arbitrage profits in the process of price regulation. It's a beautiful thing, really.

Hello, Heisenberg
But as any particle physicist will tell you, it's impossible to measure stuff without changing the thing you're measuring. Actively messing with the test samples will stir things up even further.

So it is with ETFs. Look behind the curtain and you'll find that they aren't theoretical paper constructions but actively managed portfolios. The Diamonds SPDR really does own the 30 stocks of the Dow, and must rebalance itself on occasion. The Dow is a very small basket of stocks and should be easy to maintain. But move over to the larger S&P 500 or the positively sprawling Russell 3000 and you've got a whole new ball of wax.

Add in the fact that many index-based ETFs are leveraged to increase both the positive and negative returns on any given move. Take the ProShares Ultra S&P 500 (NYS: SSO) , which aims to double the price swings of the index. Or the more extreme Direxion Daily Large Cap Bull 3x (NYS: BGU) and its bearish sister Direxion Daily Large Cap Bear 3X (NYS: BGZ) , which emulate a three-to-one magnified version of the Russell 1000 index.

These ETFs often show up on lists of large percentage moves because, you know, they try really hard to move very far. By tapping external cash sources and buying derivatives alongside the index stocks, leveraged funds can really swing hard.

That leads to a lot of trading. The Direxion Large Cap Bull ETF, for example, has an annual turnover rate in its holdings of 116% versus just 7% for the iShares Russell 1000 (NYS: IWB) ETF managed by investment management giant BlackRock (NYS: BLK) -- which tracks the exact same index! So you can see how heavy interest in leveraged ETFs can affect the market with their tremendous underlying trading needs.

But wait -- there's more risk!
New York Times columnist Andrew Ross Sorkin quotes Seabreeze Partners head Douglas Kass to describe the effect of these risk-and-return amplifiers: "They've turned the market into a casino on steroids." Furthermore, the very volatility of leveraged funds may attract outsized trading interest -- particularly from high-frequency traders with a yen for quick and large returns.

Curiously, I don't know of any deleveraged index ETFs, designed to reduce rather than increase volatility. And the ability to trade ETF options is likely used more for offense than defense; what's the point of taking a shamelessly high-risk position and then tempering the returns with covered calls? You might as well just buy the unleveraged version to begin with.

So the high-volume structure and rampant popularity of leveraged ETFs go a long way toward explaining increasing market volatility. Robots and day traders may be tempted to back up the truck to the 3x window or construct even riskier options positions around them, but we Fools know better. This crazy market is volatile enough as it is. Just pick your stocks and index funds with care, and the rest will take care of itself. Get started with this list of five stocks that The Motley Fool owns and you should, too -- it's a totally free report with plenty of portfolio-moving power.

That way, Milton (or the markets) won't burn your portfolio down at the end of the movie.

At the time this article was published Fool contributor Anders Bylund holds no position in any of the companies discussed here. Motley Fool newsletter services have recommended buying shares of BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can check out Anders'holdingsandaconcisebio, follow him on Twitter or Google+, or peruse ourFoolishdisclosurepolicy.

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