Do L&I ETFs accurately reflect daily index returns?

Leveraged and inverse exchange-traded funds contain an inherent inefficiency that can be exploited for profit by options traders, say industry experts.
Do L&I ETFs accurately reflect daily index returns?

Nearly a decade has passed since the global financial crisis, but some investors remain suspicious that they are being short-changed by derivatives-based products sold in Asia.

In this first of a two-part series, we look at concerns about leveraged and inverse exchange-traded funds (L&I ETFs) – specifically, that traders can take advantage of hedging by managers of these funds.

These products have an inherent inefficiency that creates a “field day” for market-makers (and hence more turnover), said a Hong Kong-based equity trader. “This stems from the fact that the leveraged long ETF needs to keep buying as the market rallies and selling as the market falls,” he told AsianInvestor on condition of anonymity.

Or, in the case of an inverse fund, they need to short more as markets fall and close those shorts as markets rally. This creates an optionality in both these products that experienced option-trading shops can arbitrage out, he said.

This need to constantly rebalance means they will never perform in the real world the way they look superficially on paper, he explained.

But Arjen Gaasbeek, Singapore-based managing director at Flow Traders, a market-making firm, disagreed with this view. L&I ETFs specifically track the daily performance of the underlying future, he argued, which was "clearly stated when they were launched".

Since the ETF manager usually hedges its exposure – stemming from creation and redemption requests – during the closing auction, the NAV of the fund will virtually exactly reflect the index futures’ performance, said Gaasbeek.

He cited as an example the Tokyo-listed leveraged Nikkei ETF, which has seen a tracking error of only a few basis points over the past year when comparing the daily NAV to daily index performance.

Indeed, fund managers virtually never hedge their exposure throughout the day, and doing so would lead to large tracking error for the fund compared to the index futures’ performance, said Gaasbeek.

However, he agreed that fund managers of leveraged ETFs needed to hedge themselves and that, in the event of a big market move on any given day, the trading of this hedge could exacerbate any market moves of the ETF in the last moments during the close of the market.

Hence it may be that certain option-trading firms take option positions to potentially profit from such moves, conceded Gaasbeek.

But the market move would have to be fairly large for them to do so, he noted; that is, the fund manager’s hedge would need to be big enough for the option trader to be sure it would move the market in a certain direction.

And, since market moves are usually not large enough for that to be the case, it would be hard for option traders to know which way the market would move during the close, said Gaasbeek.

“It could also happen that the expectation of a move during the closing period was overdone and that the market slightly retracts,” he added. “Therefore, I’d say we shouldn’t exaggerate these practices.”

In part two, we will look at some of the suspicions that continue to dog structured products in Asia.

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