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Do Leveraged ETFs Contribute to Share Price Volatility?

We've talked a lot about leveraged and inverse Exchange Traded Funds (LETFs)and the problems that can arise from their rebalancing. A recent paper from a group at York University asks two simple but interesting questions: does this rebalancing affect the volatility of the underlying assets? If so, can a sophisticated trader exploit that effect to achieve excess returns?

On the first question, the authors find two main results. First, the directional trades LETF providers and counterparties must undertake to hedge their exposure "can impact share prices, despite leveraged ETFs' relatively small aggregate net asset values in comparison to the overall market." Second, "the impact is economically significant only on days when the underlying market has experienced a large price swing."

The authors then speculate that these intuitive results could allow for traders to front-run LETFs and profit from the resulting increased volatility. The most profitable strategy based on their analysis had the following back tested returns:

A figure showing a line graph demonstrating the price of LETFs from 2006 to 2011.

Their results clearly demonstrate that front-running ETF rebalancing has the largest potential gains during periods of high volatility.

We've been on the record before saying that these ETFs are generally not suitable for buy-and-hold investors due to their complexity and the deteriorating effect of the frequent rebalancing. That these ETFs could also be the victim of, to use the authors' words, "predatory traders" taking advantage of the predictable trading patterns resulting from the daily rebalancing of these ETFs further highlights that they are suitable only for traders, not investors.