ETFs: Tip of the leverage iceberg

THE boom in leveraged exchange-traded funds (ETFs) may be grabbing headlines, but Bloomberg macro strategist Simon White says investors should be looking much deeper into the financial system.

“ETFs are only the tip of the leverage iceberg,” White writes in a recent Bloomberg analysis, arguing that leverage has spread far beyond retail investors into banks, hedge funds, money market funds, private credit and insurers.

He describes today’s market as “hungry for maximal returns”, with demand for leveraged products accelerating alongside the artificial intelligence (AI) rally.

Retail investors have piled into leveraged ETFs offering two or three times the daily returns of popular stocks and indices. White says demand surged earlier this year as earnings expectations for AI-linked companies, including Micron Technology, took off.

Much of the financing behind those products, however, comes from banks. “Banks supply much of what is required by ETFs, typically through total return swaps,” White writes.

Under these arrangements, banks provide the leveraged returns promised by ETFs while hedging their own exposure through cash equities and derivatives, often using repo markets to finance those positions.

White says the growth of banks’ equity repo books has closely tracked the expansion of leveraged ETFs in recent years, illustrating how banks have become central providers of leverage throughout financial markets.

Yet, ETFs are only one part of a much larger story.

White points to a period between the end of last year and early April when leveraged ETF assets declined as equity prices weakened, but banks’ equity repo positions continued to rise. “Enter hedge funds,” he writes.

During that period, White argues, hedge funds were increasing their exposure to equities through prime brokerage financing, helping explain why bank balance sheets continued expanding despite retail outflows.

“Larger hedge funds often have deep relationships with their prime brokers, including the use of the latter’s balance sheet to supply leverage in total return swaps and other structured products,” he says.

The result is that leverage is now building across multiple parts of the financial system simultaneously.

White highlights the Treasury basis trade – in which hedge funds buy US Treasuries, while shorting Treasury futures – as one of the best-known examples.

Using US Federal Reserve (Fed) data, he estimates the trade had grown to as much as US$2.4 trillion by late last year.

He also believes hedge funds are increasingly active in swap spread trades, adding another layer of leverage to markets.

The growing use of borrowed money has left banks carrying far larger exposures to hedge funds than only a few years ago.

According to White, hedge funds now repo out Treasuries to dealers and prime brokers while also taking secured loans from them, leaving banks with roughly US$4.5 trillion of exposure to hedge funds, compared with around US$2 trillion only a few years earlier.

“Hedge funds have continued to dial up their leverage,” White writes, noting that the average gross exposure of US hedge funds has almost doubled since 2022.

“The effect of leverage is taking already large nominal exposures and magnifying them.” Nor does he believe the risks stop with public markets.

“Let’s not forget about private credit,” White writes. “Its opacity is no doubt masking some quite alarming levels of leverage, but it is glib to assume it is ring-fenced from the rest of the economy.”

Banks have steadily expanded lending to private credit firms and private equity managers, increasing the potential for stress to spread if financing conditions tighten.

Even investors seeking safety in cash may not be insulated.

“Maybe you want to sit out this bacchanalia of excessive risk taking and keep your cash in a money market fund? But even there you are not safe from the tentacles of leverage,” White writes.

He points to Dallas Fed research showing that money market funds increasingly provide the funding that supports repo transactions used by hedge funds.

“Hedge fund repo borrowing and money market fund repo lending have risen in almost perfect lockstep since the late 2010s,” he writes.

In White’s view, that means investors who deliberately avoided chasing equity markets may still be indirectly financing some of the system’s most leveraged positions.

“There is, therefore, a strand that takes us from retail traders chasing leveraged upside in stocks via ETFs, to banks who are able to offer that leverage as they can offload other balance-sheet risk onto money market funds,” he writes. “There’s nowhere to hide.”

Looking ahead, White believes investors should monitor funding markets closely for early signs that the build-up in leverage is becoming unstable.

“Watch funding rates for when the leverage train begins to shudder,” he writes.

He notes that the cost of equity leverage from banks is already elevated and could rise further because the collateral underpinning many loans consists of increasingly volatile AI-related shares.

He also points to persistently high margin debt and advises investors to watch short-term interest rates and swap spreads for signs of stress emerging on bank balance sheets.

While banks today are better capitalised than before the global financial crisis, White warns their growing role as providers of leverage could become a source of instability if lending conditions tighten.

“Bank balance sheets then go from dampeners of financial market volatility, as they are now, to amplifiers of it, with unwinds and margin calls creating feedback loops that exacerbate market moves,” he writes.

As White puts it: “Leverage can create wealth at the speed of sound, but it can destroy it at the speed of light.”