Leveraged ETF Decays – Update

I measure once a month the decay of major leveraged ETFs. It may be useful for anyone using leveraged ETFs for investing, trading, or hedging.

Where does the decay come from?

Most of the time, a leveraged ETF does worse than the underlying asset leveraged by the same factor. This relative decay has several reasons: beta-slippage, roll yield, tracking errors, management fees. Only the latter is predictable. Roll yield may be prominent for commodity ETFs (leveraged or not), but beta-slippage is usually the main reason for decay. However, it doesn’t always result in decay. When an asset is trending with little volatility, a leveraged ETF can bring an excess return over the leveraged asset. You can click here to learn more about beta-slippage and examples.

The leveraged ETF decay looks like an invitation to short sellers. Click here if you want to know why it is a bad idea.

Monthly and Yearly Drifts on 4/1/2019

Definitions are needed. “Lev” is the leveraging factor. “Return” is the total return of an ETF (including dividends). “IndexReturn” is the total return of the underlying index, measured on a non-leveraged ETF (also with dividends). “ETFdrift” is the drift of the ETF relative to the leveraged index. “TradeDrift” is the drift relative to an equivalent position in the non-leveraged index. ETFdrift and TradeDrift are calculated as follows, where Abs is the absolute value operator.

ETFdrift = Return – (IndexReturn x Lev)

TradeDrift = ETFdrift / Abs(Lev.)

“Decay” is negative drift. “Month” stands for 21 trading days, “year” for 252 trading days.

A drift is a difference between 2 returns, so it can be below -100%.

BDCL and TVIX are exchange-traded notes. ETNs entail additional counterparty risks.

In 1 month:

• The inverse leveraged ETF in biotechnology (LABD) has the worst monthly decay with a drift about -1.4% normalized to 1x the underlying index exposure.

• The highest positive monthly drift is in the inverse leveraged real estate ETF (DRV) with a drift about 1% normalized to 1x the underlying index exposure.

In 1 year:

• The worse decays have occurred in leveraged biotechnology ETFs long (LABU) and inverse (LABD), with about -12% in normalized drift for both.

• The highest positive drift is for the leverage volatility ETN (TVIX) with a 5% normalized drift, in a large loss. The inverse leveraged REITs ETF (DRV) is not far behind.

Due to stock volatility in 2018, leveraged long ETFs in major stock indexes are in negative drift last 12 months. However, the 12-month drifts of inverse leveraged ETFs in the S&P 500 (SPXU) and Dow Jones (SDOW) are back in positive territory after being negative for a while. It confirms what I have often claimed in this monthly update: they may be used as hedging instruments with a moderate risk and cost. Investors having used SPXU for several years are happy with that: check here the drifts on 3 years and 7 years.

Since 2015, Quantitative Risk & Value (QRV) provides investors with a systemic risk indicator and strategies based on it. QRV features hedging tactics using a variable position in SPXU depending on the market’s risk level and the investor’s risk tolerance. Read Here how QRV can improve your investing process.

Disclosure: I am/we are long XBI, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.