Content area
Full Text
Special Issue on Exchange-Traded Funds
Edited by Peter Miu and Narat Charupat
I. Introduction
In the last few years, the market for exchange-traded funds (ETFs) has grown exponentially; there were more than 1,200 ETFs listed in the USA and Canada in the spring of 2010. In this paper, our focus is on a relatively new type of ETFs: leveraged ETFs. There are two main varieties of leveraged ETFs, those that magnify an index's return (ultra or bull ETFs), and those that track or magnify its inverse (bear ETFs). Approximately 13 percent of the ETFs traded in the USA are of the leveraged variety, and they account for 26 percent of the ETF trading volume. In Canada, the comparable numbers are 26 percent and a striking 61 percent, respectively[1] . The number of products continue to grow, and is testimony to the popularity of these funds, considering the first leveraged ETF was introduced in June 2006. However, exactly because they are relatively new investment vehicles, little academic research has focused on the performance of these funds.
The management of leveraged ETFs differ significantly from that of regular ETFs. For non-leveraged, physically replicated ETFs that track an index[2] , an arbitrage mechanism exists throughout the trading day to keep the price of an ETF in sync with the price of its underlying assets. This mechanism is a process called in-kind redemption and creation. When an ETF is trading at a premium, authorized participants[3] can swap the underlying basket of securities for shares of the ETF (and hence new shares are created). When the ETF is trading at a discount, authorized participants can redeem their shares in return for the underlying basket of securities. Hence, unlike a closed-end mutual fund, the ETF's number of shares outstanding is always changing. That said, depending on the extent of the arbitrage activities and the liquidity of the market, ETFs can still trade at a premium or a discount[4] . The underlying index may be stale, however, if it is made up of securities that are traded overseas.
Leveraged ETFs operate very differently. These funds aim to track daily returns, instead of the price of an underlying index continuously. The returns are replicated synthetically, and leverage and derivative securities such as total...