Exchange traded funds: leverage and liquidity

This paper examines the differences between leveraged and unleveraged Exchange Traded Funds (ETFs), particularly for liquidity and volatility characteristics. The impact of leverage on intraday liquidity (spread and depth) is analysed in two periods – one of normal volatility and the other of abnormal/high volatility. There is a significant difference in spread and depth of leveraged and unleveraged ETFs in periods of both normal volatility and high volatility; however, this difference is more pronounced in higher volatility periods. In high volatility periods, liquidity typically diminishes in all ETFs, and this is even more so for the leveraged ETFs. When leveraged ETFs are segregated into multiples based on their power to replicate the underlying benchmark (i.e. multiples of −3, −2, −1, 2, 3), the difference in spreads between normal and high volatility periods is typically larger. The double-leveraged ETF has the most significant difference between the positive and negative counter parts. However, the relationship in the progression of the multiples does not change linearly to correspond with the level of volatility. This may be due to the nonlinear relation between volume and volatility. We shed light on the magnification effect of financial leverage on microstructure of the ETFs.