Leveraged Exchange-Traded Funds: Their Pricing and Tracking Ability

In this paper, we examine the pricing efficiency and the tracking ability of leveraged exchange-traded funds (LETFs), which are a recent and very successful financial product. The goal of these funds is to generate daily returns that are in a positive or a negative multiple of the daily returns on an underlying benchmark. With respect to their pricing, we find that price deviations (from NAVs) are, on average, small even though large deviations can sometimes occur, especially with funds that have high leverage multiples. Bull funds (i.e., those with positive multiples) tend to trade at a discount more often than bear funds (i.e., those with negative multiples) do. In addition, funds that are on the same side of the market have price deviations that are positively correlated with one another. We also find that price deviations of bull (bear) funds are all negatively (positively) correlated with the returns on their own underlying index. These observed patterns of behavior of price deviations are consistent with the conjecture by Charupat and Miu (2011) that price deviations are caused by the funds' end-of-day exposure adjustments. Our results show that funds on the index that is most prone to the impact of the end-of-day exposure adjustments, exhibit the strongest patterns of behavior. Finally, with respect to tracking ability of LETFs, we find that LETFs are successful in generating returns that match their stated multiples on a daily basis. However, if the funds are held for a long period, significant deviations can occur.