Leveraged exchange-traded funds with market closure and frictions

Abstract

Although leveraged exchange-traded funds (ETFs) are popular products for retail investors, how to hedge them poses a great challenge to financial institutions. We develop an optimal rebalancing (hedging) model for leveraged ETFs in a comprehensive setting, including overnight market closure and market frictions. The model allows for an analytical optimal rebalancing strategy. The result extends the principle of “aiming in front of target” introduced by Gârleanu and Pedersen (2013) from a constant weight between current and future positions to a time-varying weight because the rebalancing performance is monitored only at discrete time points, but the rebalancing takes place continuously. Empirical findings and implications for the weekend effect and the intraday trading volume are also presented.