The Jump Risk of Leveraged ETFs and a High-Frequency Volatility Estimator

Abstract

This paper is the first to characterize the intraday performance of leveraged exchange-traded funds (ETFs), for which I introduce a superior volatility estimator for high-frequency analysis. Leveraged ETFs, which attempt to reproduce two or three times the daily performance of their underlying indices, experienced a growth boom during the global financial crisis of 2008-09. Just a few months after their launch in November 2008, Direxion’s triple-leveraged long and short financials ETFs were among the five most actively traded stocks in the United States. By construction, leveraged ETFs have some tracking error compared to their underlying indices over longer holding periods, which has been the focus of extant research. The short-term tracking error of leveraged ETFs is more relevant because traders only hold them for a few days, so I examine it by modifying the nonparametric jump detection test of Lee and Mykland (2008) with a new bipower variation-based subsampling and averaging high-frequency volatility estimator. Tracking error jumps are found to occur in one-fourth of trading days for leveraged ETFs that track the S&P 500 index and financial sector, and the economic significance of jump risk is substantial. Tracking error jump risk can be largely avoided, but jumps that do occur are difficult to predict.

Keywords: jump risk, tracking error, ETF, leveraged ETFs, volatility estimator

JEL Classification: G10, G11, G12, G14