What are rational uses of leveraged and inverse exchange-traded products (ETP), which offer easy access to amplified positions in various benchmark indexes spanning stocks, bonds, commodities and volatility? In their April 2020 paper entitled “Levered and Inverse ETPs: Blessing or Curse?”, Colby Pessina and Robert Whaley review the mechanics of leveraged and inverse ETPs, simulate their expected performance of those based on six popular benchmarks and document actual performance of 35 ETPs. They employ Monte Carlo simulations assuming normally distributed log returns for underlying indexes, with mean and standard deviation estimates based on historical daily returns during December 20, 2005 through March 13, 2020. Using simulation inputs as specified and data for 35 actual ETPs as available through mid-March 2020, they find that:
- Of the total 2,330 ETPs available as of mid-March 2020, 277 are leveraged or inverse products accounting for 1.2% of ETP assets .
- 83.4% of leveraged/inverse ETPs are based on equity indexes, with overall daily turnover 16.9%, indicating short-term bets of overall average duration six trading days.
- 6.1% and 5.0% of leveraged/inverse ETFs are based on commodity and volatility indexes, respectively, with much higher daily turnovers of 51% and 114%, indicating very short-term bets.
- Realized daily returns for leveraged/inverse ETPs differ from targets due to fund expenses, basis risk of underlying futures contracts and imprecise matching of number of underlying futures contracts to ETP price.
- Based on simulations as specified and actual ETP behaviors:
- If expected benchmark index return is negative (as for commodity and volatility indexes), both highly leveraged long and short funds fail at high levels of volatility.
- Compound daily leveraged return is not equal to leveraged compound return. If the benchmark index rises by 10% over a month, the return of a 2X ETP for the index is unpredictable within a range extending below 0%, depending on the actual price path of the index.
- End-of-day rebalancing of leveraged/inverse ETPs is destabilizing. If the benchmark index rises during the day, issuers of associated leveraged/inverse ETPs must buy swaps or futures to re-hedge positions, thereby driving the index even higher and requiring further re-hedging in a positive feedback loop.
- Front-running of ETP rebalancing is a concern. Traders familiar with re-hedging demands may exacerbate end-of-day index volatility by stepping in with trades just before ETP managers re-hedge.
In summary, evidence from simulated and actual leveraged/inverse ETPs indicates that these products are suitable not for buy-and-hold investments or hedging, but only for short-term directional bets on underlying indexes.
Cautions regarding findings include:
- Simulations involve simplifications of reality that may affect findings.
- Leverage/inverse ETPs rely on financial soundness of offerors that represent an additional risk.
See also “Unintended Characteristics of Leveraged and Inverse ETFs”, the source paper for which is referenced frequently in the above paper.
