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Leveraged ETF Arbitrage?

Posted in ETFs by teslik on November 5, 2009

In response to yesterday’s post (which, to my excitement, got picked up by FT Alphaville), a friend sent me the following chart. It shows FAS and FAZ, Direxion’s leveraged ETFs tracking, respectively, the daily performance of the Russell 1000 financial services index and the inverse of the same index. Both ETFs are 3x leveraged, and as you can see, they have both fallen significantly thus far this year — FAS by around 30%, and FAZ by nearly 100%.


My friend pointed out that there would be an easy arbitrage play here if you could simply short both of these ETFs at the same time. Unfortunately, while you can short an ETF, it would be difficult to short sell a leveraged ETF in practice, because you’d have to find somebody to lend it to you — and most brokerages serving retail investors won’t do this, presumably because they understand that the deal would likely net them a loss in the long-run.

One caveat:  even if you found somebody willing to lend you shares of both FAS and FAZ, so that you could sell them short, the success of this arbitrage strategy would still depend on the volatility of the market, as this post on SeekingAlpha points out. The author, Larry MacDonald, encourages anyone trying this strategy to seek out leveraged ETFs in the markets most likely to be volatile over time.

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