Leveraged ETFs: Where ETF Decay Rules
By: Jonathan Edwards Wed, Dec 23, 2009
During a time when many investors are still underwater on their portfolios since the financial meltdown, it is increasingly tempting to use leveraged exchange traded funds (ETFs) to gain back losses.
Leveraged ETFs use derivatives to underpin the underlying investment, and suggest investors can earned double (or triple) the expected return on the supporting index, similar to returns from margin investing. This is not without risk. Along with the increased chance at a significant loss, leveraged ETFs experience a form of decay that further deteriorate your potential return. ETF decay occurs as the investment loses value over time when the market price experiences fluctuations. When the market does not have clear direction, leveraged ETFs will experience a loss of value as compared to its multiple on the underlying portfolio.
Some believe a 2x leveraged ETF that loses 5% on day 1 and gains 5% on day 2 has experienced ETF decay since it has not regained its position to the original value (scenario A). This is a common misconception about ETF decay. The stock is trading short of the original value because the companies making up the underlying portfolio have not regained their collective value. Stocks do not trade based on percentage fluctuations; instead, they trade at the underlying asset value. While ETF decay makes up a portion of this difference, this is not how to measure it. Decay should only be measured once the index has returned to its original value, allowing us to determine the difference between the return expected (zero) and the return achieved by the leveraged ETF (including ETF decay).
Scenario B considers an index that drops $25 before returning to its original value. The percentage increase on day 3 is larger than 2.50% since the base is $975 and also affects the ETF (increase of 5.13% instead of 5.00%). After a short-term fluctuation, the index is back to its original value ($1,000) whereas the ETF has settled at $99.87. The loss of 0.13% is ETF decay. If the ETF were to mirror the index perfectly (whether up or down) without decay, the ETF should be back at its original value as well.
The above scenario assumes a decrease of 2.5% on the index before recovering over a 2-day period. If we were to run the recurring scenario for 50 trading days, the effective ETF decay would be 3.16% (compared to 0.13%). This percentage is lost value that the investor incurs while holding leveraged positions.
Instead of returning to the original value every second day, consider the scenario where the index falls $25 every day for 25 days, then regains $25 per day. This will again return the index to full value ($1,000) at day 50. In this case, the ETF decay is measured at 8.01% – think twice before holding leveraged ETF’s when the direction is downward. On ETFs that boast 3 times the daily return, the ETF decay in this scenario is magnified to 22.25% (compared to 8.01% for 2x ETFs).
Although you MAY earn more than the index using leveraged ETFs, the decay outlined above indicates that it is typical to earn less than the expected return by using leveraged ETFs. Regardless of the fluctuation pattern over time, leveraged ETF’s will experience decay that cuts into the final return for the investor. Note that non-leveraged ETFs do not experience ETF decay as the daily change will mirror the index.
Key takeaways:
- ALWAYS understand the buildup of the ETF. If it is based on a subsector or index, it is essential to understand the industry and the companies that will have the largest impact on the trading price. Understand that any change to an index company’s valuation may have a significant impact to the corresponding leveraged ETFs.
- ALWAYS understand the major influences of the stock price. For example, HOU (long oil) does NOT fluctuate with the price of oil. Rather, it is base on movements in the futures market of crude.
- Use leveraged ETFs with caution and only for short-term positions. ETF decay does exist and active trading in the leveraged ETF market should only be used if substantial losses can be withstood. Leveraged ETF investing is not for the weak at heart.
Disclosure: Long market.
Image credit: lastnychero under a Creative Commons License.
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Tags: ETF Decay, Leveraged ETFs
Great article Jon. I’ve experience a similar decay in the past when dealing with contango on some oil ETF’s (I actually think it was HOU) – maybe not the same source but I can relate to what you mentioned about the expected return needing to account for decay on the ETF as well.
When you say leveraged ETFs should be used simply for short-term trading – can you clarify on how short exactly?
To minimize the negative effect on your return, leveraged ETF’s should ideally only be used intra-day (as most ETF’s are designed to track the daily returns of a basket of stocks). For investors who do not have the capacity for high volume trading but want to take advantage of a leveraged position, a few days may be appropriate if you expect a flat to upward-trending market. A longer position may be held to gain greater gains as the market rises, but investors should understand a portion of their expected return will be decayed in the process.
Leveraged ETF’s are a balance between greater exposure and time. While using these types of investments can lead to stronger returns, there may very well be another strategy with the same expected return, but lower risk.
Wow that is a great point, thanks for pointing that out! I’ll be back again soon, I hope to see some more great content in the future from you!