The Dynamics of Leveraged and Inverse Exchange-Traded Funds

Journal Of Investment Management (JOIM), Fourth Quarter 2009

Posted: 19 Jan 2010 Last revised: 3 Jun 2010

See all articles by Minder Cheng

Minder Cheng

ThirdStream Partners LLC

Ananth Madhavan

BlackRock, Inc.

Date Written: January 19, 2010

Abstract

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. While these funds are primarily used by short-term traders, they 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 unified 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. We show that the daily re-leveraging of these funds can exacerbate 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: Leveraged and inverse ETFs, market microstructure

JEL Classification: G00

Suggested Citation

Cheng, Minder and Madhavan, Ananth, The Dynamics of Leveraged and Inverse Exchange-Traded Funds (January 19, 2010). Journal Of Investment Management (JOIM), Fourth Quarter 2009. Available at SSRN: https://ssrn.com/abstract=1539120

Minder Cheng (Contact Author)

ThirdStream Partners LLC ( email )

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

Ananth Madhavan

BlackRock, Inc. ( email )

400 Howard Street
San Francisco, CA 94105
United States

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