The Dynamics of Leveraged and Inverse-Exchange Traded Funds

Journal of Investment Management, Winter 2009

Posted: 24 Apr 2009 Last revised: 17 Nov 2009

See all articles by Minder Cheng

Minder Cheng

ThirdStream Partners LLC

Ananth Madhavan

BlackRock, Inc.

Date Written: November 4, 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 uni ed 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

Suggested Citation

Cheng, Minder and Madhavan, Ananth, The Dynamics of Leveraged and Inverse-Exchange Traded Funds (November 4, 2009). Journal of Investment Management, Winter 2009, Available at SSRN:

Minder Cheng

ThirdStream Partners LLC ( email )

650 California Street
31st Floor
San Francisco, CA 94108
United States

Ananth Madhavan (Contact Author)

BlackRock, Inc. ( email )

400 Howard Street
San Francisco, CA 94105
United States

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