Are Concerns About Leveraged ETFs Overblown?

Abstract

Leveraged and inverse exchange-traded funds (ETFs) have been heavily criticized for exacerbating volatility in financial markets because it is thought that they mechanically rebalance their portfolios in the same direction as contemporaneous returns. We argue that these criticisms are likely exaggerated because they ignore the effects of capital flows on ETF rebalancing demand. Empirically, we find that capital flows substantially reduce the need for ETFs to rebalance when returns are large in magnitude and, therefore, mitigate the potential for these products to amplify volatility. We also show theoretically that flows can completely eliminate ETF rebalancing in the limit. * The views stated herein are those of the authors and are not necessarily the views of the Federal Reserve Board or the Federal Reserve System. For helpful comments, we thank Matt Gustafson, Jerry Hoberg, Jeremy Ko, and seminar participants at the Securities and Exchange Commission.