The Impact of Leveraged and Inverse ETFs on Underlying Stock Returns

Abstract

Leveraged and inverse ETFs (LETFs) were introduced in 2006 and their popularity surged starting in 2008. As of the first quarter of 2012 there were over 200 such ETFs with over $30 billion in assets under management (AUM). By late 2008 there was concern about their late-day impact on stock prices and by 2009 they were accused of causing market-wide volatility. A vocal set of market participants insist that LETF-related trading causes excess volatility and manipulates prices while others insist that the AUM is too small to impact the market. The pitch of the rhetoric reached sufficient levels to motivate a Senate Banking Committee hearing in October 2011. We examine six such LETFs and their impact on the trading of 63 real estate sector stocks. We find that late-day LETF rebalancing activity significantly moves the price of component stocks, increases their volatility, and that some of this impact is reversed in the first hour of the next day. The impact is the greatest for smaller, less actively traded, more volatile stocks. Our evidence is also consistent with predatory trading by strategic investors exploiting the predictable late-day order flow.