Year of Graduation
Financial Markets and Financial Institutions
Leveraged Exchange-traded Funds (LETFs) are tempting investment products because of the high potential returns that they promise. However, most unsophisticated investors are not aware of the structural mechanics of these instruments and, thus, underestimate the risks that leveraged ETFs pose. This paper analyzes the tracking performance of LETFs on medium-term and long-term maturity US Treasury indices during the post-crisis period, January 2010-2018, and examines the sources and determinants of the return deviations between LETFs on indices with different maturities. First, we confirm that the tracking errors are significantly different from zero for all sample LETFs and LETFs with higher leveraged multiples and longer investment horizon have greater tracking errors. We also show that there are differences between tracking errors of LETFs on indices with different maturities. Specifically, the tracking errors of LETFs on longer-maturity index are higher than those on medium-maturity index. Moreover, we find that the volatility of the equity markets and the volatility of changes in the term structure spread are positively associated with the tracking errors and tracking errors’ differences, while the average change in risk free rate has a negative influence on the tracking errors and tracking errors’ differences. These findings can help individual and institutional investors, as well as portfolio managers to assess the performance, understand potential risks of leveraged ETFs, and plan accordingly when building investment and hedging strategies using these products.