Leveraged ETFs: A Risky Double That Doesn't Multiply by Two

Trainor, Jr., William J.; Baryla, Jr., Edward A.
May 2008
Journal of Financial Planning;May2008, Vol. 21 Issue 5, p48
Academic Journal
• This study investigates the long-run return properties of leveraged ultra-bullish" exchange traded funds (ETFs), which seek to multiply the daily performance of market indexes both on the long and short side. • Although leveraged ETFs can multiply index returns by a specific amount on a day-to-day basis, long-run returns cannot similarly be multiplied by the leverage ratio due to the constant leverage trap and the lognormal nature of continuously compounded returns. (Fund issuers make no representations regarding potential long-run return performance.) • Over 50 leveraged ETFs have come to the market in just one year. An examination of these funds relating to major stock indexes shows that, on average, leveraged funds are meeting their specified daily leverage targets. But there is significant volatility in meeting this target on any given day. • Using Monte Carlo simulation, it is found that a typical 2× leveraged stock ETF is likely to only magnify the index return by 1.4 times on an annual basis for holding periods out to ten years. But the risk as measured by the standard deviation of returns remains doubled, while the magnitude of extreme negative returns can quadruple. • The paper also compares leveraged ETFs with buying an index fund using a simple margin account It finds the leveraged ETFs a superior long-term alternative due to their relative lower cost. • Given the risk/return trade-off leveraged ETFs offer, long-term investors should be considerably wary. Extreme swings in value are inherent in this type of fund. • Leveraged ETFs seem to be a useful tool for short-term investors or traders who are willing to extend themselves by making a market call.


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