Price inefficiency and stock-loan rates of leveraged ETFs

Price inefficiency and stock-loan rates of leveraged ETFs

Leveraged exchange-traded funds (ETFs) have attracted considerable attention from investors, market commentators and academics. For investors, the leveraged ETF offers the possibility of increased leverage and shorting through inverse funds. Among market commentators, leveraged ETFs are a popular topic, both to articulate bullish or bearish views on a particular sector, or to consider their performances relative to the benchmarks. Mathematicians and quants have also been active in research on leveraged ETFs, based on the fact that constant leverage implies negative convexity (that is, a negative Gamma exposure to the underlying asset).

The knowledge we have about leveraged ETFs has increased significantly. But with this better understanding comes the possibility that there may be a reaction from market participants. Is negative convexity priced in? If leveraged ETFs underperform their benchmarks in volatile markets–a well-documented fact – does this affect shorting costs for these products? This article will review some of the issues involved in leveraged ETFs, based on a study of one-day returns of leveraged exchange-traded funds and their borrowing costs in the period from June 26, 2009 to July 8, 2011.

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