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 exaggerated because they ignore the effects of capital flows on ETF rebalancing demand. Empirically, we find that capital flows substantially reduce ETF rebalancing demand. After accounting for capital flows and standard risk factors, we find that the impact of ETF rebalancing on late-day returns and volatility is economically insignificant. Theoretically, we show that flows completely eliminate ETF rebalancing in the limit.
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