Saturday, October 31, 2009

Leveraged ETFs - the rules of the game

As volatility returns to the markets, it's worth revisiting leveraged ETFs and the tracking error associated with these products. The rules of the game are simple:

1. Leveraged ETFs do well relative to the underlying index in trending markets,
2. underperform in mean-reverting markets,
3. underperform significantly in mean-reverting high volatility markets,
4. underperform over longer periods of time,
5. inverse (bear) leveraged ETFs underperform more than the equivalent leverage bull ETFs. The tracking error for a bear ETF is equivalent to a bull ETF with an extra turn of leverage. That is an inverse ETF tracking error is equivalent to that of a 2x bull ETF. The error for a 2x inverse ETF is equivalent to that of a 3x bull ETF, etc.

The chart below shows a potential underperformance (in a mean-reverting market) for leveraged bull ETFs over a one-month period (roughly) as a function of daily volatility.

The chart below shows the same for inverse ETFs (bear ETFs).

Here is an example of what happens with leveraged ETFs over a longer period of time. The chart below compares TNA, a 3x Russel 2000 ETF with the performance of Russell 2000 (small cap index). The index is up some 12% YTD, while TNA instead of being up three times that is actually up less than half for the year.

So if you really like risk, by all means take advantage of all the leverage available out there (before the SEC takes some "anti-derivatives" action against these products), but keep mindful of the nasty tracking error.
Related Posts Plugin for WordPress, Blogger...
Bookmark this post:
Share on StockTwits