ETFs, Leverage, and the Hidden Risks Behind Market Crowding

Exchange-Traded Funds (ETFs) have transformed modern investing. With over 4,300 U.S. listed ETFs holding more than $10 trillion in assets as of August 2025 (Bloomberg), they are now core building blocks of portfolios from retail traders to large institutions. In 2025 alone, more than 640 ETFs were newly released.

But as the ETF ecosystem expands, especially with the recent boom in single-stock leveraged ETFs, investors should pause and ask:

Are these products reshaping volatility, crowding, and systemic risk?

ETF Growth and Stock Volatility

• Academic research (Ben-David, Franzoni & Moussawi, Journal of Finance, 2018) finds that stocks with higher ETF ownership are more volatile and have lower earnings-price responsiveness, reflecting a shift from company-specific fundamentals to basket trading.

• A 2025 study (Passive Investing and Market Quality) shows that when passive ETF ownership of a stock rises, bid-ask spreads widen and exposure to market-wide liquidity shocks rises.

• This means: even if you pick strong companies, their trading behavior can look more like the index they belong to will have less alpha, more beta.

Crowding and Market Downturn Risk

• During March 2020, corporate HY bond ETFs traded at discounts of up to 9% below NAV (BIS Quarterly Review, 2020 No.6). Arbitrage broke down, as dealers’ balance sheets couldn’t absorb the flood of redemption pressure.

• Equity ETFs can also drive flow herding. Index rebalancing events often spark abnormal volatility in affected stocks, with spreads widening around rebalance dates. An increase in ETF ownership is associated with higher trading costs and a decline in pricing efficiency of the underlying component securities, with a one-percentage point increase in ETF ownership leading to approximately a 9 percentage point increase in the average annual change in return synchronicity. (Israeli, Lee & Sridharan, 2017).

• The implication: in stress periods, ETFs may not just mirror volatility but they can amplify it.

The Rise of Single-Stock Leveraged ETFs

Since 2022, issuers have launched products offering 2x or -2x daily exposure to single names like Nvidia, Tesla, or Apple. These ETFs may look like powerful trading tools, but the risks are sharper:

• Path dependency: A stock that falls 10% one day and rebounds 10% the next leaves a 2x ETF down ~4%, not flat.

• Volatility amplification: Studies show single-stock leveraged ETFs trade with higher volatility than their underlyings and suffer from systematic underperformance due to daily rebalancing costs (Bessembinder, 2025).

• Crowding risk: The majority of AUM is concentrated in a handful of mega-cap tech names. If those stocks face a sharp downturn, forced daily rebalancing could accelerate late-day selling pressure, creating self-reinforcing volatility spirals.

What Investors Should Watch

• ETF Ownership Share: If a stock is >15–20% owned by ETFs, expect more factor-driven swings and less idiosyncratic price action.

• NAV vs. Price Gaps: Persistent ETF discounts signal stress in arbitrage mechanisms such as bond ETFs in 2020.

• Leveraged Products: Single-stock leveraged ETFs should be treated as short-term trading tools, not investments. Long-term holders risk decay and amplified losses.

ETFs are here to stay and they bring enormous benefits in terms of access, diversification, and cost. But investors must recognize that the proliferation of ETFs, especially leveraged single-name products, has side effects: more volatility, greater crowding, and higher tail risk in downturns.

The key is awareness and positioning. In a world where flows increasingly drive fundamentals, those who understand the hidden mechanics of ETFs will have an edge in managing risk and capturing opportunity.

Sources:

1. Ben-David, Itzhak and Franzoni, Francesco A. and Moussawi, Rabih, Do ETFs Increase Volatility? (November 30, 2017). Journal of Finance, Forthcoming, Fisher College of Business Working Paper No. 2011-03-20, Swiss Finance Institute Research Paper No. 11-66, AFA 2013 San Diego Meetings Paper, Charles A. Dice Center Working Paper No. 2011-20, Available at SSRN: https://ssrn.com/abstract=1967599 or http://dx.doi.org/10.2139/ssrn.1967599

2. Sirio Aramonte & Fernando Avalos, 2020. "The recent distress in corporate bond markets: cues from ETFs," BIS Bulletins 6, Bank for International Settlements. https://ideas.repec.org/p/bis/bisblt/6.html

3. Höfler, Philipp and Schlag, Christian and Schmeling, Maik, Passive Investing and Market Quality (September 11, 2023). Proceedings of the EUROFIDAI-ESSEC Paris December Finance Meeting 2024, Available at SSRN: https://ssrn.com/abstract=4567751 or http://dx.doi.org/10.2139/ssrn.4567751

4. Israeli, Doron and Lee, Charles M.C. and Sridharan, Suhas A., Is There a Dark Side to Exchange Traded Funds? An Information Perspective (January 13, 2017). Review of Accounting Studies, Vol. 22, Pages 1048-1083, 2017, Available at SSRN: https://ssrn.com/abstract=2625975 or http://dx.doi.org/10.2139/ssrn.2625975

5. Bessembinder, Hendrik (Hank), Levered Single-Stock ETFs (July 28, 2025). Available at SSRN: https://ssrn.com/abstract=5369417 or http://dx.doi.org/10.2139/ssrn.5369417

Disclaimer: This material is provided for informational purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any securities or investment products. Any such offer will only be made through formal offering documents and only to persons who are both (i) “accredited investors” as defined under Rule 501(a) of Regulation D of the Securities Act of 1933 and (ii) permitted investors under applicable exemptions, including Section 3(c)(1) of the Investment Company Act of 1940.

Nothing herein should be construed as investment, legal, or tax advice. Past performance is not indicative of future results, and all investments involve risk, including the risk of loss of capital. Prospective investors should consult with their own advisors before making any investment decision.