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Are leveraged and inverse ETFs the new portfolio insurers?

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Abstract

This paper studies Leveraged and Inverse Exchange Traded Funds (LETFs) from a financial stability perspective. Mechanical positive-feedback rebalancing of LETFs resembles the portfolio insurance strategies, which contributed to the stock market crash of October 19, 1987 (Brady Report, 1988). I show that a 1% increase in broad stock-market indexes induces LETFs to originate rebalancing flows equivalent to $1.04 billion worth of stock. Price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks. Implied price impact calculations and empirical results suggest that they contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011 when the European sovereign debt crisis came to the forefront. Although LETFs are not as large as portfolio insurers of the 1980s and have not been proven to disrupt stock market activity, their large and concentrated trading could be destabilizing during periods of high volatility.

Suggested Citation

  • Tugkan Tuzun, 2013. "Are leveraged and inverse ETFs the new portfolio insurers?," Finance and Economics Discussion Series 2013-48, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2013-48
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    References listed on IDEAS

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    1. Jarrow, Robert A., 2010. "Understanding the risk of leveraged ETFs," Finance Research Letters, Elsevier, vol. 7(3), pages 135-139, September.
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    1. Juan Laborda & Ricardo Laborda & Javier Cruz, 2024. "Can ETFs affect U.S. financial stability? A quantile cointegration analysis," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 10(1), pages 1-24, December.
    2. Qing Bai & Shaun A. Bond & Brian Hatch, 2015. "The Impact of Leveraged and Inverse ETFs on Underlying Real Estate Returns," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 43(1), pages 37-66, March.
    3. Saæglam, Mehmet & Tuzun, Tugkan & Wermers, Russ, 2021. "Do ETFs increase liquidity?," CFR Working Papers 21-03, University of Cologne, Centre for Financial Research (CFR).
    4. Tamara Teplova & Sergei Gurov, 2025. "Nonlinear intraday trading invariance in the Russian stock market," Annals of Operations Research, Springer, vol. 352(3), pages 441-469, September.
    5. Hurlin, Christophe & Iseli, Grégoire & Pérignon, Christophe & Yeung, Stanley, 2019. "The counterparty risk exposure of ETF investors," Journal of Banking & Finance, Elsevier, vol. 102(C), pages 215-230.
    6. Bogousslavsky, Vincent & Muravyev, Dmitriy, 2023. "Who trades at the close? Implications for price discovery and liquidity," Journal of Financial Markets, Elsevier, vol. 66(C).
    7. Pauline Shum & Walid Hejazi & Edgar Haryanto & Arthur Rodier, 2016. "Intraday Share Price Volatility and Leveraged ETF Rebalancing," Review of Finance, European Finance Association, vol. 20(6), pages 2379-2409.

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