Last week saw another round of ETF histrionics. The latest salvo was an old saw—that leveraged and inverse funds were to blame for the increased volatility in the U.S. markets.

Media bigwigs hit the theme not once, but twice: First, Andrew Ross Sorkin of the New York Times posted a piece titled "Volatility, Thy Name Is E.T.F."; then, Herb Greenberg of CNBC added his own thoughts in "Proof: ETFs a Self-Fulfilling Prophecy."

It's easy to understand the concern. Average investors—which we presume means everyone but those most evil of cartoon villains, hedge fund managers—hate volatility, and for good reason. Volatility means uncertainty and, paraphrasing Yoda: Uncertainty leads to anxiety; anxiety leads to bad decisions; and bad decisions lead to suffering.

I'm no apologist for leveraged and inverse funds. I think they're inappropriate for the vast majority of investors.

I know firsthand that there are financial advisors and investors who have money in those type of funds and still don't understand how they work. But there's a big difference between being a niche, complex and sometimes misused product and being a threat to modern capitalism. Yet that's precisely what they're often made out to be.

Too often, those accusations are made on hunches and correlation, with no causal link or hard-data support. We figured it would pay to actually look at the data independently and put that data out in the open.

Leveraged And Inverse Funds Both Trade With The Market

The first thing to understand is that all leveraged and inverse funds—regardless of whether they are betting for or against the market—are "pro-cyclical." That is to say, the daily rebalancing the funds are required to do to maintain exposure each day is always in the direction of the market.

This is counterintuitive and often misreported. Most people assume that leveraged and inverse funds balance each other out. In fact, both types of funds must buy extra exposure on days that the markets go up, and sell exposure when markets go down.

Here's a quick look at how it works in principle. Imagine you're dealing with a single share of a $100 fund, at one of five different leverage factors, and comparing an up and a down day in the markets.

The key thing to note here, again, is that it doesn't actually matter whether a fund is long the market or short the market; the end-of-day trades are always in the direction of the day's trading.

A fund that's levered on a day its index is up needs to get an even bigger chunk of exposure tomorrow, effectively reinvesting its profits. A fund that was short will find itself with too deep a hedge, and will need to unwind its negative exposure—thus also putting buying pressure into the close.

It's important to note that the funds themselves aren't buying or selling anything. All of the levered and inverse funds in the U.S. get their exposure through total return swaps.

Their rebalancing trade is simply resetting the level of the swaps with counterparties—big banks—who, in turn, need to hedge their own risk.

Whether they do that by buying and selling stocks at the close, or simply using the futures markets, eventually, someone in this chain of counterparties will be either making a naked bet on the market (unlikely) or hedging out their risk by putting trades into the actual securities in the market.

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