Rebalancing Counterparties for Inverse and Leveraged Exchanged-Traded Products

Leveraged exchange-traded products (LETPs) have been widely criticized for generating inferior long-term returns due to rebalancing trades designed to maintain target leverage ratios. If so, their rebalancing trading partners should generate superior long-term returns. This conceptual article identifies the investment strategies of natural LETP rebalancing counterparties to better understand the LETP ecosystem. Contrary to common suggestions, inverse LETPs are not natural rebalancing counterparties to direct LETPs. Nor is the reverse true. Direct and inverse LETPs are momentum strategies and necessarily have contrarian rebalancing counterparties, such as a traditional unlevered, long-only, constant-mix investment strategy, like the ubiquitous balanced mutual fund. The prevalence of these rebalancing counterparties explains why LETP rebalancing has little empirical impact on end-of-day returns and volatility.