Financial Innovation, Investor Behavior, and Arbitrage: Implications from Levered ETFs

Abstract:     
In the light of standard theories of financial innovation, levered ETFs are unusual in that although they are largely marketed to retail investors, they increase, rather than decrease, information sensitivity. How does this affect market liquidity? Controlling for the underlying index, the turnover in the levered ETF market is several times higher than that in the regular ETF market. However, this does not imply that the levered ETF market is more liquid, as we also find that levered ETFs have significantly higher bid-ask spreads and lower liquidity ratios. One interpretation is that levered ETFs appeal certain type of investors who are interested in short-term levered speculation or hedging. In aggregate, the total cost levered ETF investors incur is around 5% of the market capitalization, or around $1 billion, each year. Moreover, levered and regular ETF investors appear trade differently: For levered (regular) ETFs, monthly fund flows are strongly negatively (positively) correlated with both current and past month returns. Finally, due to limits of arbitrage, ETF prices converge to their fundamental values, but only gradually.

Number of Pages in PDF File: 31

Keywords: Financial Innovation, Leverage, Investor behavior, Index.

JEL Classification: G11, G23

working papers series