Long-Term Growth Rate of Leveraged ETFs
Exchange-traded funds (ETFs) are popular financial products designed to track the value of a reference asset or index. With trillion dollars of assets under management, ETFs are traded on major exchanges like stocks, even if the reference itself may not be traded.
Within the growing ETF market, leveraged ETFs (LETFs) are created to generate a constant multiple β, called leverage ratio, of the daily returns of a reference index. For example, the ProShares Ultra S&P 500 (SSO) offers to generate twice (β = 2) the daily returns of the S&P 500 index.
In the LETF market, the most common leverage ratios are β ∈ {1, 2, 3} and β ∈ {−1, −2, −3}. In particular, investors can take a bearish position on the reference by taking a long position in an LETF with β < 0 without the need of borrowing shares or a margin account. For many speculative investors, LETFs are highly accessible and liquid instruments that give a leveraged exposure, and particularly attractive during periods of large momentum.
For LETF holders and potential investors, it is crucial importance to understand the price dynamics and the impacts of leverage ratio on the risk and return of each LETF. A number of market observations suggest that LETFs suffer from the volatility decay effect, which reflects the value erosion proportional to the realized variance of the…
