Preying on Leveraged ETFs
Yinhong Zhao
Abstract
This paper documents predatory trading on leveraged exchange-traded funds (LETFs) in Korea. LETFs are mandated to rebalance at the close of every trading day, a publicly predictable trade both in the same direction as and proportional to the day’s return. In response, predatory speculators trade the underlying ahead of this rebalance, distort the closing price against the funds, and liquidate into the order their own trading has enlarged. Consistent with this mechanism, Korean stocks tracked by LETFs exhibit extreme volatility. They reverse about half of their first-day response to overnight U.S. market returns by the next close and oscillate for several days thereafter, a pattern absent among large-capitalization controls. Our quantification implies
that the self-reinforcing rebalancing loop raised SK Hynix’s annualized volatility from 83.1% to 124.9% over three months and cost its products’ predominantly retail holders 30.4% of their initial investment. Dispersing the rebalance across the day, as Korean regulators recommended, fails to dampen the predatory incentive, whereas adding a dedicated rebalance at market open would cut SK Hynix holders’ losses by about half.