The world’s largest leveraged exchange-traded fund is getting too big for the market it was designed to track.

Nomura Asset Management Co. will halt subscription orders for itsNext Funds Nikkei 225 Leveraged Index ETF and two other funds from Friday, it said in a statement on its website. The money manager, which relies on the futures market to deliver two times the daily return of Japan’s most famous stock index, said liquidity isn’t deep enough to ensure it can meet that target.

Surging inflows from individual investors have made the Nikkei 225 ETF one of the biggest players in Japan’s futures market, sparking concern among some analysts that the fund’s trades are exacerbating price swings. Assets under management have doubled in just five months to 734 billion yen ($6.16 billion), even as the benchmark index fell 13 percent from this year’s peak in June.

“It seems that the ETF has become too big and is moving the market, and that they’re unable to secure the liquidity they need,” said Michiro Naito, an equity derivatives and quantitative strategist at JPMorgan Securities Japan Co. 

David Fuller's view

Generally speaking, a high level of liquidity reduces volatility because institutional investors can enter or exit that market more easily.  You can see this when comparing a chart of the S&P 500 Index (arguably the most liquid stock market index in the world), over the medium to longer term with indices of most smaller developed countries such as Denmark or Ireland, not to mention any emerging markets such as Brazil or India.  

However, the proliferation of hedge funds and particularly high-frequency trading (HFT) in many liquid markets certainly increases the intraday volatility, while producing occasional meltdowns, such as we last saw on 24^th August.  The HFT promoters and apologists frequently mention their contribution to liquidity.  Yes, but on days when they account for most of the volume, and other investors are temporarily frightened into inactivity, we get either small meltups or much bigger meltdowns, usually caused by front running.    

The proliferation of ETFs can also increase volatility in ways that we have not yet fully seen.  While I regard the popularity of this ETF as another sign that Japan is developing its biggest bull market in over 25 years, I also assume that Nomura’s comments in the article above are not just promotion.  Japan is more liquid than most other stock markets and if one of its ETFs is judged to be too big, consider how much more readily this could occur in other stock markets which are far less liquid.   

I think this is more of a future risk than an imminent one but I would not want to be too enamoured of ETFs.  I would far prefer an investment trust (closed-end fund) if that alternative is available.  When investors have piled into an ETF, they are inevitably driving the market higher.  That becomes a problem if / when the same people eventually take fright for whatever reason, and head for the exit at the same time.  The risks are smaller with ITs because managers are not forced to sell.  If investors are exiting an IT its discount to NAV will widen, which may well attract additional investors.  After all, when one can purchase a diversified asset for 10% to 20% below its NAV, that is usually a good investment for the medium to longer term.