The Dynamics of Leveraged and Inverse-Exchange Traded Funds
November 4, 2009
Journal of Investment Management, Winter 2009
Leveraged and inverse Exchange-Traded Funds (ETFs) have attracted significant assets lately. Unlike traditional ETFs, these funds have \leverage" explicitly embedded as part of their product design and are primarily used by short-term traders, but are gaining popularity with individual investors placing leveraged bets or hedging their portfolios. The structure of these funds, however, creates both intended and unintended characteristics that are not seen in traditional ETFs. This note provides a unied framework to better understand the underlying dynamics of leveraged and inverse ETFs, their impact on market volatility and liquidity, unusual features of their product design, and questions of investor suitability. In particular, leveraged funds are not well understood both by investors and industry professionals. The daily re-leveraging of these funds creates profound micro structure effects and exacerbates volatility towards the close. We also show that the gross return of a leveraged or inverse ETF has an embedded path-dependent option that under certain conditions can lead to value destruction for a buy-and-hold investor. The unsuitability of these products for longer-term investors is reinforced by the drag on returns from high transaction costs and tax inefficiency.
Keywords: Exchange-Traded Funds, Leveraged ETF, Liquidity, Microstructure
JEL Classification: G20, G18, G14
Date posted: April 24, 2009 ; Last revised: November 17, 2009
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