Preying on Leveraged ETFs

Abstract

We argue that arbitrageurs preying on the closing rebalances of leveraged exchange-traded funds (LETFs) contributed to the Korean market's extreme volatility in 2026. An LETF's mandated daily rebalance is sized by the day's return, which generates an upward-sloping demand at market close. Arbitrageurs therefore pre-position, enlarge the fund's order, and liquidate into the demand they have induced. Consistent with this mechanism, Korean stocks tracked by LETFs reverse about 60% of their first-day response to pre-open U.S. news by the next close, a phenomenon not exhibited in any control groups. Our quantification implies that self-referential rebalance raised SK Hynix's annualized volatility from 84.8% to 136.7% over nine weeks and transferred 19% of terminal wealth from the products' predominantly retail holders. Dispersing the rebalance into day sessions may backfire, as proposed by Korean regulators, and we propose a few alternative designs.