Financial Innovation, Investor Behavior, and Arbitrage: Implications from the ETF Market

Regular and levered ETFs are markedly different financial innovations. Regular ETFs improve liquidity: they are more liquid than their underlying stocks. In contrast, although the levered ETF market has a substantially higher turnover, it also has a significantly higher bid-ask spreads and larger price impacts. Our interpretation is that levered ETFs are appealing to short-term levered speculators. The aggregate cost levered ETF investors incur is around 10% of the market capitalization, or around $2 billion, each year. Moreover, regular ETF investors appear to be momentum traders, while levered ETF investors are contrarians: For regular (levered) ETFs, their monthly fund flows are strongly positively (negatively) correlated with past returns. Finally, arbitrage forces push ETF prices partially towards their NAVs, and this mechanism is less effective for levered ETFs than for regular ones