The Leveraged ETF Question Nobody Is Asking

The Leveraged ETF Debate Is Missing a Key Question

The debate surrounding leveraged ETFs has intensified in recent months.

Much of the discussion has focused on investor suitability, whether retail investors understand leverage, daily rebalancing, and the risks associated with holding these products for extended periods.

Those are important discussions.

But after nearly three decades in ETF trading and capital markets, including leading ETF Capital Markets during one of the most volatile periods in market history, I believe another question deserves equal attention.

Should every underlying security automatically qualify to support a leveraged ETF?

A Lesson From the COVID Market Turmoil

My perspective on that question changed dramatically during the COVID market turmoil of 2020.

At the time, I was responsible for ETF Capital Markets at VanEck. As markets experienced unprecedented volatility, the SEC reached out to ETF issuers to better understand the premiums, discounts and trading dislocations that had developed across certain ETF products.

VanEck participated in those discussions because several of our ETFs experienced unusual market conditions.

What quickly became apparent was that not all ETF dislocations were created equal.

When Bond ETFs Became Price Discovery Tools

Our fixed income ETFs experienced discounts because many of the underlying bonds simply weren't trading. Dealer balance sheets contracted, transactions became scarce, and many evaluated bond prices became stale because they no longer reflected executable market levels.

In that environment, ETFs were providing price discovery while the underlying bond market struggled to establish current prices.

The Different Challenge Facing Gold Miner ETFs

Our gold miner ETFs presented a very different challenge.

Unlike fixed income, GDX and GDXJ were highly liquid ETFs. They traded significant volume every day and were supported by experienced market makers and a robust creation and redemption process. The ETFs themselves weren't the problem.

The issue was the extraordinary market environment.

Gold and silver sold off sharply, mining stocks declined even more dramatically, and several of the underlying U.S. securities fell by more than 10%, triggering the SEC's Rule 201 short-sale circuit breaker.

At the same time, portions of the basket were no longer trading because several international markets had already closed, reducing the flexibility available to market makers attempting to hedge risk.

When Hedging Becomes the Problem

Throughout the day, I spoke with the Lead Market Makers supporting these products.

As ETF sell orders continued to enter the market, they attempted to hedge by selling the underlying basket. Under normal market conditions, that process is routine.

During this period, however, hedging became significantly more difficult. By late afternoon, many market makers had not been able to complete their hedges as efficiently as they normally would.

At the same time, the leveraged ETFs still had to complete their required end-of-day rebalance.

That meant additional selling pressure entered a market where liquidity providers were already carrying substantially more risk than usual.

The Lead Market Makers explained that they simply lowered their bids until they reached prices where they believed they were being adequately compensated for assuming that additional overnight risk.

To me, that wasn't a failure of the ETF structure.

It was the market accurately pricing the true cost of liquidity under extraordinary conditions.

The Real Question: Can the Market Absorb the Leverage?

That experience fundamentally changed the way I think about leveraged ETFs.

The discussion shouldn't simply focus on whether investors understand leverage.

It should also focus on whether the underlying market possesses the capacity to absorb the additional hedging and rebalancing demands that leveraged products create during periods of severe market stress.

Liquidity Matters More Than Many Realize

One important point often gets overlooked.

GDX and GDXJ were, and remain, highly liquid ETFs.

If even products built on highly liquid underlying portfolios experienced meaningful stress during extraordinary market conditions, it raises an important question about leveraged ETFs built on individual stocks with significantly smaller public floats, lower trading volumes, thinner options markets, and more limited market depth.

It's also worth noting that much of the industry ultimately moved away from 3x leveraged products toward 2x exposure.

While there were several reasons for that evolution, it reflected the reality that higher leverage requires significantly greater rebalancing activity during periods of large market moves.

Why South Korea Has Reignited the Discussion

Recent events in South Korea have renewed this discussion. Concentrated positioning in leveraged ETFs, combined with large end-of-day rebalancing activity, has prompted regulators and market participants to reexamine how leveraged products can influence trading in the underlying securities during periods of market stress.

Similar questions have also emerged around highly concentrated positions held by certain investment firms, underscoring how leverage, liquidity, and market structure can interact in ways that aren't always apparent during normal market conditions.

These events don't suggest that leveraged ETFs are inherently flawed.

Rather, they reinforce the importance of ensuring that the underlying securities possess sufficient liquidity and market capacity to support the additional hedging and rebalancing demands that leverage creates.

Should Market Capacity Become Part of the Approval Process?

I'm not suggesting that leveraged ETFs should be restricted or that innovation should slow.

Far from it.

Leveraged ETFs serve an important purpose and, in my experience, generally perform exactly as designed.

What I am suggesting is that as innovation continues, perhaps the regulatory conversation should expand beyond investor suitability and begin asking whether the underlying market itself is sufficiently resilient to support these products during periods of extreme stress.

Should regulators consider minimum standards for public float, average daily dollar volume, securities lending availability, options market depth, or demonstrated market resiliency before approving leveraged ETFs tied to individual securities?

A Conversation Worth Having

I don't pretend to have all the answers.

But after witnessing firsthand how market structure, hedging capacity and leveraged rebalancing interacted during one of the most volatile periods in modern financial history, I believe it's a conversation worth having.

Because in the end, leverage isn't necessarily the risk.

Market capacity may be.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.