PORTFOLIO STRATEGY. Exhibit 2: S&P s End of Day Moves Last Week. Market Commentary 19 August Exhibit 1: ETF Trading Spikes Up

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1 (212 ( PORTFOLIO STRATEGY Victor Lin Victor.lin@credit-suisse.com Trading Strategy Leveraged ETF Rebalancing in Perspective Market Commentary 19 August 2011 Key Points Last week s sudden spike in volatility and large intraday swings left people looking for possible culprits. Leveraged ETF rebalancing was one topic revisited by media for exacerbating intraday moves towards the close. In our report, we try to quantify the impact of this rebalancing and put it into the proper perspective. Our findings show that the leveraged ETF rebalancing trades are unlikely to be the most influential factor in driving intraday swings into the close. Less liquid spaces like small caps and specific sectors may be more likely to be affected on rare days with extreme moves, but liquidity needs are often quickly met in the same way as for typical index rebalances that occur throughout the year. Exhibit 1: ETF Trading Spikes Up 45% 4 35% 3 25% ETF % of all US $Value Traded Much ado about leveraged ETFs With equity volatility doubling recently, some of the same topics that came up two years ago during the credit crisis have resurfaced as people look for possible culprits. ETFs have received some blame for the increasing volatility, although we believe it s a case of confusing correlation with causation (see our report ETFs and Correlation: The Chicken or the Egg?). As more macro-suited trading tools, ETF trading has increased at a faster pace than single stock volumes. Over the past week, they ve made up about 4 of overall value traded in the U.S. of which leveraged ETF trading is about 1. This past week, large intraday moves have caused media to revisit the ability of leveraged ETFs to impact markets, especially towards the end of the trading day. In our report Triple Trouble two years ago, we explained the mechanics of leveraged ETFs and their daily rebalancing requirements. To summarize, the leveraged funds need to releverage their gains/losses each day to provide their promised exposure. The amount they need to rebalance on the close can be approximated by: (Fund assets) x (Underlying Index Return) x [(Leverage Factor) x (Leverage Factor 1)] Overall, we find it less likely to be significantly impacting the equity markets as a whole. In less liquid or narrower spaces like small caps and specific sectors, there may be higher relative turnover on days with extremely large moves. However, this activity is similar to other large liquidity events like index rebalances, which occur throughout the year without notoriety and whose liquidity needs are met by program trading desks and the participation of arbitrageurs amongst others. It s also important to remember that the leveraged ETF rebalancing is concentrated at the end of the day and a function of how much volatility there already was in the market (i.e. they didn t cause the market slide!). Exhibit 2: S&P s End of Day Moves Last Week 2 15% 1 5% Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Source: Bloomberg

2 Create/Redeems Often Counter Rebalancing One especially important point to note is that since many traders use leveraged ETF for extremely short-term trades, they can be quick to redeem profits and/or initiate reversion trades. This leads to a reduction/countering of the rebalancing needs. On 8/8, the largest rebalancing day with the market down over 6%, many leveraged short holders took profits and many traders initiated positions in the leveraged long ETFs. Ultimately, the net result was a reduction of rebalancing demand by 3 in the large cap space and 5 in the small cap space. While not quite as significant as 8/8, other days last week also had rebalancing reductions of Leveraged Large Cap Rebalancing $3 $ $(3) $(4) Large Cap Leveraged ETFs Create/Redeem Rebalancing EOD Rebalancing Leveraged Small Cap Rebalancing $ Small Cap Leveraged ETFs Create/Redeem Rebalancing EOD Rebalancing How Much to Rebalance Based on our estimates and taking into account creations/redemptions (see sidebar), leveraged ETF rebalancing between 8/8 and 8/11 ranged from.7 to.2 billion in the large cap space, and $730mm to.2bn in the small cap space. As we discussed in Triple Trouble, rebalancing for the leveraged ETFs are always in the direction of the market s move for the day unless creations/redemptions exceed the releveraging needed to be done. Therefore, market reversals like on the 11 th would not be indicative of leveraged ETF flows directly moving the market. Exhibit 3: Leveraged ETF Rebalancing Last Week Amt to Rebal $4 $3 $ $(3) $(4) Large Cap Small Cap Market Move (Right Axis) 6% 4% 2% 2% 4% 6% 8% Rebalance Trades Manageable in Size Now that we have an approximation of the size of the rebalancing that needs to be done, we can put the amount of trading into proper perspective versus MOC prints and overall volumes in the last half hour of the trading day. In theory, rebalancing should be done at the close; in practice, many market makers may start trading a half hour to one hour in advance (we use the last half hour in our analysis here). In the large cap space, the amount of end of day rebalancing in the leveraged ETFs represented about 20-3 of MOC totals, and only around 5-6% of trading in the last 30 minutes. In our opinion, these values would be unlikely to cause the market to move violently. Market Move Exhibit 4: Rebalance trades as a percentage of MOC and trading in last half hour Large Cap Leveraged ETF Rebalancing Small Cap Lever aged ETF Rebalancing % of MOC % of Last 30 min % of MOC % of Last 30 min 2

3 Exhibit 5: Lev ETF Rebalancing vs Index Rebalance $6 $5 $4 $3 $0 Large Cap Rebalancing on 8/8 (Large Cap Lev. ETFs) Average S&P Quarterly Rebalance Exhibit 6: Lev ETF Rebalancing vs Index Rebalance $5 $0 Rebalancing on 8/8 (Small Cap Lev. ETFs) Small Cap Russell MOC (Last June Review) Average Russell Rebalance Exhibit 7: Lev ETF Rebalancing Estimated Impact Universe Trade Size Estimated Impact (Bps) Est. Index Points S&P 500.2bn Russell bn * In the small cap space, the amount of rebalancing was about 8 compared to MOC totals for 3 of the 4 days (on 8/9 the value spiked up to 17, partially since the MOC print was smaller than usual). However, the last half hour is probably more representative and the amount of estimated rebalance trading was typically about 2 or less of the total trading during this time. While not insignificant, these totals are not outrageous either, especially in light of how infrequently they occur and how the market typically responds to large liquidity events (e.g. index rebalances). Just Like an Index Rebalance But Smaller In many ways, the rebalancing that the leveraged ETFs need to do is similar to typical index rebalances we see throughout the year. However, the leveraged ETF rebalancing is typically considerably smaller. Even with a 6% market move, leveraged ETF rebalancing was still only about half of that of a typical S&P quarterly rebalance (which are already relatively low turnover as far as index rebalances go). On the small cap side, the Russell 2000 rebalances once a year and even the trading on close during this past June s reconstitution dwarfed the highest leveraged ETF rebalancing last week of.2bn. Estimated Impact Well Short of Actual Move In terms of impact of the largest rebalance trades, our models (assuming a high rate of participation) estimate that a.2bn trade of the S&P 500 over a 30 minute time period would have impact of about 20bps, or 2.4 index points. On the small cap side, we estimate a.2bn trade over the same time period would cost about 120bps, or 7 index points. *Note that our estimates assume a fully complete trade, whereas large baskets like the Russell 2000 are often optimized for liquidity reasons which would likely lessen impact. In either case, the moves we saw last week were generally much larger than our impact models estimate given the size of the rebalances. This would seem to suggest to us that other factors were more influential for the wild end of day moves. Furthermore, when looking at just how volatile the market was the rest of the day, the end of day moves don t seem that out of place (perhaps with Tuesday, 8/9 as the exception). Exhibit 8: Estimated Rebalance Impact vs Actual Index Moves Last Week S&P 500 Intraday Moves Russell 2000 Intraday Moves Aug 9 Aug 10 Aug 11 Aug 8 Aug 9 Aug 10 Aug 11 Aug Remaining Move on Close Est Rebalance Impact on Close Remaining Move on Close Est Rebalance Impact on Close Prev Close to 3:30pm Prev Close to 3:30pm 3

4 Leveraged ETF Assets Steady While trading has increased in leveraged ETFs in the past week, assets have remained at consistent levels over the past several years. Since 2008, leveraged equity ETFs have hovered around 0bn in assets. Within leveraged equity ETFs, about half of the assets are in the large cap space, and about 1 each are in the small cap and financial categories. Leveraged Equity ETF Inverse and Long Assets $ $5 $0 12/1/2007 3/1/2008 Leveraged Equity ETF Assets 6/1/2008 9/1/ /1/2008 3/1/2009 6/1/2009 Inverse ETFs 9/1/ /1/2009 3/1/2010 Long ETFs Leveraged ETF Asset Breakdown Alternatives Currency Commodities Equity FixedIncome 6/1/2010 9/1/2010 Real Estate Energy Total Market Small Cap Financials Large Cap Leveraged ETF Assets a Directional Signal? In the past, some have viewed leveraged ETF assets as a directional signal for the market. However, recently the signal s been a little murky as inverse and long assets hover close to even. Leveraged ETF Asset Breakdown % ETF Assets Inverse or Long /1/2007 3/1/2008 6/1/2008 9/1/ /1/2008 3/1/2009 6/1/2009 9/1/ /1/2009 3/1/2010 6/1/2010 9/1/ /1/2010 3/1/2011 6/1/ /1/2010 3/1/ Inverse Long S&P 500 (Normalized, Right axis) 6/1/2011 S&P 500 (Normalized) Arbs Step in to Provide Liquidity Even if we were to assume that last week s end of day moves were exacerbated by leveraged ETF rebalancing, we also can t ignore what happened on Thursday, 8/11 (we focus on the small cap space since it s more likely to be affected based on relatively less liquidity) as well as other times in the past. With the market significantly up on the day as of 3pm, leveraged ETF funds would be expected to be big buyers on the close barring a huge reversal. From 3pm to 3:40pm the index continued to rise, perhaps aided by arbs seeking to profit from the end of day buying. However, the index actually decreased into the close, possibly as the liquidity the leveraged ETF funds needed was more than met (perhaps an example of arbs contributing to market efficiency). Exhibit 9: Russell 2000 Intraday on 8/ Extreme Moves are Atypical While the amount to rebalance can be relatively large, this is only the case on days with extremely large moves. Without extreme volatility, the rebalancing is small and this explains why there has been little made of leveraged ETF rebalancing since 2008/2009 even though actual assets have remained the same. Aside from the unprecedented crisis in 2008, there have been very few trading days with moves of at least 4% (and only 1 in 2010). Rebalancing in the size we saw last week is pretty rare on a historical basis (a 3 or 4 standard deviation event) when the average magnitude market move is usually around 1%. Exhibit 10: Extreme Moves of More than 4% are Usually Rare Trading Days with Move Larger Than 4% Arbs Buying? Trading Day Moves More than 4% More than 4% VIX Level Liquidity exceeds lev. ETF buying demand? 4

5 Playing the Blame Game It s understandable for the investment community to look for possible explanations in periods of extreme volatility. Outside of leveraged ETFs, there s also been speculation that option hedging has contributed to the late day swings. Yet, a recent report by Credit Suisse Derivatives Strategist Dmitry Novikov disputes the degree to which this hedging could affect the market End of Day Volatility Facts vs. Fiction. Even assuming the (unlikely) worst-case scenario when all S&P related delta-hedging flows are routed in the same direction, the total gamma did not exceed $40 billion over the past few weeks, while S&P (SPY ETF plus SPX futures) daily volume reached new highs of $400 billion or more. Exhibit 11: S&P Option Hedging Small Relative to Overall Volume Volume ($) Gamma ($) USD (billion) Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Source: Credit Suisse: Derivatives Strategy In summary, we think that the proper perspective needs to be taken in these times of increased anxiety. Trading naturally increases with volatility as portfolios are rebalanced, investment views change, risk tolerance is adjusted, and perceived opportunities arise. 5

6 Credit Suisse Portfolio Strategy USA Phil Mackintosh Victor Lin Ana Avramovic Stephen Casciano Europe Colin Goldin Mark Buchanan Marwan Abboud Disclaimer: Please follow the attached hyperlink to an important disclosure: Structured securities, derivatives and options are complex instruments that are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation for any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation. Use the following links to read the Options Clearing Corporation s disclosure document: Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. Asia This material has been prepared by individual traders or sales personnel of Credit Suisse Securities Limited and not by the Credit Suisse research department. It is Karan Karia karan.karia@credit-suisse.com provided for informational purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. It is intended only to provide observations and views of individual traders or sales personnel, which may be different from, or inconsistent with, the observations and views of Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions of Credit Suisse. Observations and views expressed herein may be changed by the trader or sales personnel at any time without notice. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. The information set forth above has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, but each of the trader or sales personnel and Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or changes in market factors. This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view of a particular market. Credit Suisse may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. The most recent Credit Suisse research on any company mentioned is at , CREDIT SUISSE 6