Leveraged ETF Mechanics Illustrated

I’ve written previously about the not-so-advanced math needed to understand how long term leveraged returns do not equal compounded daily leverage returns. That’s why, if you hold an Ultra-ETF for an extended period of time, your long term return doesn’t necessarily equal twice the return of the underlying index.

SymmetricInfo has a two-part series illustrating in detail, simply, how and why this performance difference occurs, and diagrams how the path-dependance of the underlying index effects the end result of the Ultra-ETF.  Their conclusion (using TBT – the UltraShort Treasury ETF – as their target of discussion:

“Many investors who are betting on price declines in treasuries are buying levered short ETFs and holding them past one day. When investors do this they are making a highly complex bet on the future path and volatility of the underlying bond index. Therefore if investors want to short treasuries using a levered ETF, they should think through what path they expect treasuries to follow and whether those price declines are likely to take place during a high or low volatility regime.

If  the expected decline in treasuries coincides with higher volatility and/or a higher degree of mean reversion in bond prices (perhaps reflecting short term uncertainty in the market), then holding onto a levered short treasury ETF over that period will likely underperform simply shorting an unlevered bond fund (e.g  TLT equity) using leverage. It is entirely possible that investors who end up being right on the direction of the underlying bond index and would have profited from shorting it, may instead lose money buying a levered short ETF.”

Symmetric Info Part I

Symmetric Info Part II

If you are still confused about this topic, these posts are a MUST read.


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