Leveraged Exchange-Traded Funds with Market Closure and Frictions

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. This paper was accepted by Agostino Capponi, finance. Funding: M. Dai acknowledges support from the National Natural Science Foundation of China [Grant 12071333], the Hong Kong Polytechnic University [Grant P0039114], and the Singapore Ministry of Education [Grants R-146-000-243/306/311-114 and R-703-000-032-112]. H. M. Soner acknowledges partial support from the National Science Foundation [Grant DMS 2106462]. C. Yang acknowledges support from the Chinese University of Hong Kong [Grant 4055132 and a University Startup Grant]. Supplemental Material: Data and the online supplement are available at https://doi.org/10.1287/mnsc.2022.4407 .