Structural Slippage of Leveraged ETFs

17 Pages Posted: 10 Aug 2012 Last revised: 18 Sep 2012

See all articles by Marco Avellaneda

Marco Avellaneda

New York University (NYU) - Courant Institute of Mathematical Sciences; Finance Concepts LLC

Doris Dobi

Courant Institute of Mathematical Sciences; New York University (NYU)

Date Written: August 10, 2012

Abstract

The daily rebalancing of a leveraged exchange traded fund(LETF) requires the fund manager to systematically modify the amount of index exposure. In order to achieve the investment objective of the fund, managers of LETFs use total return swaps with the appropriate leverage ratio. This daily rebalancing may open the possibility of front-running and other market frictions. We constructed shorting trades in order to capture any existing slippage resulting from the daily rebalancing of LETFs. Our data unequivocally shows that the cumulative effect of rebalancing costs cannot be ignored. For holding periods of one day, even after accounting for compounding costs, LETFs fail to perform as expected.

In order to gain a full understanding of the performance of these trades, it was crucial to take into account the borrowing rates for shorting LETFs. We calculated the difference between the slippage and the borrowing rates and found that in 16 out of the 21 trades the mean value of the difference is strictly positive with 95 percent confidence. Precisely because LETFs have negative expected returns with respect to their benchmark index, if they are not offset by high borrowing costs, then systematic shorting yields an arbitrage opportunity.

Keywords: Leveraged ETFs, slippage, short-selling costs

Suggested Citation

Avellaneda, Marco and Dobi, Doris, Structural Slippage of Leveraged ETFs (August 10, 2012). Available at SSRN: https://ssrn.com/abstract=2127738 or http://dx.doi.org/10.2139/ssrn.2127738

Marco Avellaneda (Contact Author)

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Doris Dobi

Courant Institute of Mathematical Sciences ( email )

New York University
New York, NY 10012
United States

HOME PAGE: http://cims.nyu.edu/~dobi/

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