Why leveraged etfs are bound to deteriorate

The construction of this index is described in Schwert and the index used is the capital index no dividends reinvested.

The orange circles show popular leverage rates 1, 2, 3, and just for show, 4. It can be seen that increasing leverage from zero to 1 increases the annualised return as would be expected. But then, contrary to what the myth propagators say, increasing the leverage even further still keeps increasing the returns. There is nothing magic about the leverage value 1. There is no mathematical reason for returns to suddenly level off at that leverage.

The myth propagators are wrong. We can see that returns do drop off once leverage reaches about 2. That is the effect of volatility drag. What the myth propagators have forgotten is that there are two factors that decide leveraged ETF returns: benchmark returns and benchmark volatility. If the benchmark has a positive return then leveraged exposure to it is good and compensates for volatility drag.

Since the return is a multiple of leverage and the drag a multiple of the leverage squared then eventually the drag overwhelms the extra return obtained through leverage. So there is a limit to the amount of leverage that can be used. The formula for the long term compound annual growth rate of a leveraged ETF cannot be written in terms of just the benchmark return and volatility.

It also involves terms containing the skewness and kurtosis of the benchmark. Its derivation and form is published in the paper that accompanies this article. R is the quantity you use to calculate the long term buy-and-hold return of the ETF. R is a quadratic function of k with a negative coefficient for the square term.

That means we will always get the parabola shape shown above and we will always have a maximum for some value of k. This formula actually the more accurate version including skewness and kurtosis is discussed at depth in the full paper. It is a formula that occurs in an appropriate form in the Kelly Criterion and Merton's Portfolio Problem.

Its appearance here as the result of an optimisation is no surprise. All three quantities have been annualised since most people are used to thinking in annual returns but they are still daily quantities. The chart can be tricky to understand. But the important point to note is that for a given Daily Return as you move horizontally rightwards on the chart in the direction of increasing Daily Volatility the return R becomes more blue — i. R decreases. This is the effect of volatility drag.

The benefit of this chart is that you can plot leveraged ETFs on the chart simultaneously for all leverages k. The numbers 1 to 4 on the chart in the next section show where the points for leverage 1 to 4 lie. Since daily volatility and daily return both increase linearly with k then the varying leverages draw out straight lines across the chart.

Since the R contours are curved the straight lines have to cross the curves. Therefore every line has an optimum value of R. That is, there is an optimal leverage for which the long term return is maximised. And that optimum leverage is almost always greater than 1. Plotting some of these markets and leaving others out for clarity on our contour chart shows how R varies according to leverage and allows us to see all the markets at once.

The pattern is quite clear. Over various markets over various time periods mostly the last 2 or so decades except for the Nikkei the optimal leverage is about 2. The exception is the Nikkei Only invest if you are confident the product can help you meet your investment objectives and you are knowledgeable and comfortable with the risks associated with these specialized ETFs.

Search SEC. Securities and Exchange Commission. Investor Alerts and Bulletins. What Are Exchange-Traded Funds? Real-Life Examples The following two real-life examples illustrate how returns on a leveraged or inverse ETF over longer periods can differ significantly from the performance or inverse of the performance of their underlying index or benchmark during the same period of time. Between December 1, , and April 30, , a particular index gained 2 percent.

However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25 percent. During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent.

An ETF seeking to deliver three times the inverse of the index's daily return declined by 90 percent over the same period. Things to Consider Before Investing The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them. Before investing in these instruments, ask: How does the ETF achieve its stated objectives?

And what are the risks? Ask about—and be sure you understand—the techniques the ETF uses to achieve its goals. For example, engaging in short sales and using swaps, futures contracts, and other derivatives can expose the ETF—and by extension ETF investors—to a host of risks. What happens if I hold longer than one trading day? While there may be trading and hedging strategies that justify holding these investments longer than a day, buy-and-hold investors with an intermediate or long-term time horizon should carefully consider whether these ETFs are appropriate for their portfolio.

As discussed above, because leveraged and inverse ETFs reset each day, their performance can quickly diverge from the performance of the underlying index or benchmark. All rights reserved. Inflation is at a year high. But these Mad Money megatrends could help you fight back. As of p.

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