Solving the Return Deviation Conundrum of Leveraged Exchange-Traded Funds

Abstract

The large deviation of the actual return of a leveraged exchange-traded fund (LETF) from the leveraged multiple of the underlying index return has drawn considerable attention from investors, regulators, and the financial media. Despite this attention, the sources and fundamental determinants of the LETF return deviation remain unidentified. This study constructs a clear, unified, objective, and executable framework that addresses the behaviors, sources, and determinants of the LETF compounding and noncompounding deviations. Our theoretical predictions and empirical results hold the promise of guiding investors, regulators, financial advisors, and portfolio managers toward a thorough understanding of the return behavior of LETFs.

Can international LETFs deliver their promised exposure to foreign markets?

“…As explained in Cheng and Madhavan (2009), Avellaneda and Zhang (2010), as well as Tang and Xu (2013), if an investor holds an ILETF for multiple trading days, in addition to the four deviation components mentioned in the previous subsection, there is an additional deviation component due to the fact that the cumulative leveraged target return is different from the product between the product multiple and the cumulative target return. Following Tang and Xu (2013), we define this additional deviation as the compounding deviation.…”

“…This deviation component reflects fund provider's ability to achieve its target. Tang and Xu (2013) argue that the swap-related LIBOR interest payment (receipt) will lead to negative (positive)…”

“…As in Tang and Xu (2013), we define an inefficiency deviation as the LETF actual market return less the NAV return. This deviation reflects market inefficiency or trading frictions.…”

“…What are the determinants of this difference? First, as explained by Tang and Xu (2013), the holding period LIBOR interest should be driving this NAV deviation if an ILETF sponsor uses swap contracts or other derivatives to deliver leveraged exposure. For simplicity, without resort to financial derivatives, to achieve twice the exposure to the underlying index, an ILETF fund needs to borrow extra fund to invest in the underlying index.…”

“…What drives the compounding deviation? To address this question, we carry out a set of analysis in Table 8 using the framework from Tang and Xu (2013).…”