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What You Need To Know About The Decay Of Leveraged ETFs

(2019-08-04 05:53:10) 下一个

https://seekingalpha.com/article/1864191-what-you-need-to-know-about-the-decay-of-leveraged-etfs

 

What You Need To Know About The Decay Of Leveraged ETFs

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52 comments
 
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 Includes: AGQSDSSLVSPXUUPRO
Summary

The simple math of leveraged ETF decay.

In fact the drift is not always a decay.

It is path dependent.

This idea was discussed in more depth with members of my private investing community, Quantitative Risk & Value. Start your free trial today »

Leveraged ETFs are known for their natural decay. On the long term, holding a position in an N-times leveraged ETF is generally worse than holding an N-times leveraged position in the underlying asset. But few people really understand the reason, which is called beta-slippage.

To understand what is beta-slippage, imagine a very volatile asset that goes up 25% one day and down 20% the day after. A perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price:

(1 + 0.25) x (1 - 0.2) = 1

And the perfect leveraged ETF?

(1 + 0.5) x (1 - 0.4) = 0.9

Nothing has changed for the underlying asset, and 10% of your money has disappeared. Beta-slippage is not a scam. It is the normal mathematical behavior of a leveraged and rebalanced portfolio. In case you manage a leveraged portfolio and rebalance it on a regular basis, you create your own beta-slippage. The previous example is simple, but beta-slippage is not simple. It cannot be calculated from statistical parameters. It depends on a specific sequence of gains and losses.

At this point, I'm sure that some smart readers have seen an opportunity: if we lose money on the long side, we make a profit on the short side, right?

The reality is more complicated for various reasons.

First, these products may be very volatile.

Second, to sell them short, you need to borrow shares from your broker. The interest rate is variable and sometimes prohibitive.

Third, borrowed shares can be called back at any time for any reason by the broker.

Smart people had the idea to take market-neutral short positions in opposed leveraged ETFs. Unfortunately, such strategies may be very sensitive to starting dates (article here).

 

Are all leveraged ETFs losers on the long side and dangerous on the short side? Not for some of them. For example, leveraged S&P 500 ETFs have a lower beta-slippage than most leveraged ETFs, which makes SPXU and SDSgood candidates for hedging a stock portfolio (article here).

In a trending market, beta-slippage can even become positive. Let's go back to the math: the simplest trending market is two consecutive days in the same direction. Imagine an asset going up 10% two days in a row.

On the second day, the asset has gone up 21%:

(1 + 0.1) * (1 + 0.1) = 1.21

The perfect 2x leveraged ETFs is up 44%, more than twice 21%:

(1 + 0.2) * (1 + 0.2) = 1.44

A leveraged ETF in a steady bullish trend may outperform its leveraging factor. But it depends on the sequence of losses and gains, and cannot be predicted or even calculated with a statistical model.

Here is an example with UPRO in the last twelve months:

 

12-month return

11/25/2012 to 11/25/2013

S&P 500

27.5%

UPRO

114.4%

The "intuitive" return of UPRO should be 27.5 x 3 = 82.5%.

Another past example using SLV (silver) and AGQ (silver 2x):

 

6-month return

11/1/2010 to 4/30/2011

SLV

81.1%

AGQ

195.3%

During this rally, AGQ returned more than twice SLV's return.

Does it also work with leveraged inverse ETFs in bearish markets? The math works, not psychology. Fear generally makes bearish markets chaotic, not trending.

Beta-slippage is path-dependent. If the underlying gains 50% on day 1 and loses 33.33% on day 2, it is back to its initial value, exactly like in the first example. This time, the 2x ETF loses one third of its value, which is much worse than 10% in the first case:

(1 + 1) x (1 - 0.6667) = 0.6667

Without a demonstration, it shows that the higher the volatility, the higher the decay. Hence, its name: "beta" is a statistical measure of volatility. However, it is a bit misleading because the decay cannot be calculated from beta.

Update (March 2019): the drift being path dependent means not only it cannot be calculated from statistical aggregate data, but also it cannot be anticipated from price targets calculated with technical analysis methods. All we can do is observe a product's behavior on various durations. Here is an article with 3-year and 7-year time frames: Long-Term Drifts Of Leveraged ETFs. For 1-month and 1-year time frames, I publish a monthly dashboard with current decays of leveraged ETFs in stock indices, sectors, oil, gas, gold and silver. It is a must read for investors using leveraged ETFs for trading or hedging. To be notified, click "follow" at the top of this article.

 
Seasonal patterns don't work every single year as a market timing indicator. Quantitative Risk & Value (QRV) provides you with a more realistic quantitative approach, for a world of probabilities instead of just risk on/risk off. It includes a systemic risk indicator and strategies based on it. Get startedwith a two-week free trial and see how QRV can improve your investing decisions.

Disclosure: I am/we are long SDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: long SDS for hedging purposes

 

 

 
The theory of decay is not logical. The base value of the underlying asset changes significantly in your example, and this factor is sadly overlooked. (1+.50) x (1-.40) of course comes out to less than the original asset value, because 40% drop of $1.50 is a greater overall value than a 50% in crease of a lower numerator. Decay isn't real. It is a misunderstanding of simple math and base values.
23 Apr 2019, 05:32 PMReply0Like
 
So anyone wants to talk about UBT/SSO return in rate rising environment and market going down:)? Is this a good time to start such a portfolio?
27 Oct 2018, 01:01 PMReply0Like
 
It makes sense that the leveraged ETF won't perfectly match long-term returns. After all if two investors bought the ETFs on different dates they would expect different long-term results. And the ETF can't have two prices at once :)

 

It looks like a lot of the examples you cited actually have followed the expected path in recent years. Which ETFs have had noticeable beta decay by going down when you would expect them to go up?
22 Nov 2017, 01:19 AMReply0Like
 
Insightful article - thanks! But some confusion remains on my part on where the "decay" hides itself. Do stock charts NOT take into account the "beta decay?" Are they misleading?? Let me be specific. I went back and charted three ETFs (SPY, SSO and TQQQ) using well known trading platform charts, Fidelity's Active Trader Pro. October 7th, 2011 to today's record index highs, July 20th, 2017. Almost 5.75 years of seemingly good growth in all three. Not annualized, but total change.

 

From:
SPY Low of Day 10/7/2011: 107.43
SSO Low of Day 10/7/2011: 17.09
TQQQ Low of Day 10/7/2011: 6.41 (record highest volume day, btw)

 

To:
SPY close of day 7/20/2017: 247.10
SSO close of day 7/20/2017: 112.23
TQQQ close of day 7/20/2017: 93.23

 

producing a total change (over about 5.75 years) of:
SPY: 130.01%
SSO: 556.7%
TQQQ: 1,354.45%

 

Putting $1,000 net into each (NOT taking into account ETF fees) on October 7th, 2011 should produce, according to charting software:
SPY $2,300.10?
SSO $6,567.00?
TQQQ $14,544.50?

 

WHERE IS THE "BETA DECAY?" Exactly. All had plenty of dips along the way. Are the charts deceptive? Are ETF fees eating a significant amount .. to boot? How much? This would go a long way in clearing my confusion on the topic of 'leveraged ETF decay.' Thank you.
20 Jul 2017, 10:57 PMReply1Like
 
I got these numbers... 10-7-2011 to 7-20-2017

 

SPY + 15.20% / yr Sharpe 1.43
SSO +29.95% Sharpe 1.32

 

The lower Sharpe of SSO is the decay

 

BTW... for XIV

 

XIV 60.48% / yr Sharpe 1.07

 

So SPY has the best risk adj ret.
27 Nov 2017, 12:15 AMReply0Like
 
Hi Fred, hope you are doing well,
I want to follow Gold, do you recommend buying NUGT ? it moves three times the market move?
If no, what is the best ETF to buy to long Gold?
And what about DUST if I want to short Gold?
Thank you
20 Feb 2017, 05:40 AMReply0Like
 
Hi.
Not only de CARG is important. The final balance too:

 

$10000 10 year

 

1x: CARG 10%
3x: CARG 28% 28/10 = 2,80

 

1x: Final Balance: $25937
3x: Final Balance: $118059 118059/25937 = 4,55
31 Oct 2016, 10:19 AMReply0Like
 
I have just one question on the "DECAY' problem. The beginning example was crystal clear. My question is, if dealing with a stock mutual fund using double or triple returns, is it possible to have a negative total value ? For example in your beginning example, The regular fund goes up 25%, then down 20%. If the down part had been down 51%, what would be the value of the accelerated fund, a minus number? Thank you.
06 Aug 2016, 06:05 PMReply0Like
 
I was just introduced to your Leveraged ETF decay article. Have a question. I sometimes buy leveraged bond funds, where the fund borrows money at a low interest rate to purchase higher paying bonds. If a fund borrows 50% of fund asset value to buy more assets it would be referred to as 33 1/3% "leveraged" . Does your decay concept take place in the fund? I would think there is no "rebalancing" , but I am a beginner. Thank you
21 Jul 2016, 04:54 PMReply0Like
 
Hi Fred,
Thanks for the insightful article. Do you have any comments/thoughts on LABU? Any insight is appreciated. Thanks again
Kenny
07 Feb 2016, 07:08 PMReply0Like
 
Thanks, Varan! That is surprisingly close.

 

How do you define "Modified Minimum Volatility"?

 

Cheers from Osaka,

 

john
23 Jan 2016, 08:52 PMReply0Like
 
QLD/UBT 1988-2016

 

Annually rebalanced Risk Parity
Sharpe 1.0 Sortino 2.1 Max DD 22.1% CAGR 22.5%

 

Annually rebalanced Minimum Volatility
Sharpe 0.98 Sortino 1.9 Max DD 19.3% CAGR 19.8%

 

Annually rebalanced Modified Minimum Volatility 
Sharpe 1.1 Sortino 2.15 Max DD 19.0% CAGR 22.2%
23 Jan 2016, 03:57 PMReply1Like
 
hi Fred, thanks for this article
why 3 times leverages are not recommended for long term? What would happen if I bought now such as UWTI and kept it for long term? since I am a long term investor, it's ok for me if it goes down today, but I am sure that it will recover back in the future!
Does it have an expiration date since it deals with contracts ? and does reach ZERO and bankrupt ??
21 Jan 2016, 10:45 AMReply1Like
 
http://bit.ly/1NqUStA

 

2X seems to be the ideal leverage.
22 Jan 2016, 10:39 PMReply0Like
 
Yeah, but the 98% drawdown of QLD and 82% drawdown of SSO (based on simulation for 1988-2016 - 2X daily return of ^NDX for QLD, and 2X daily return of VFINX for SSO), both during the three year period 2000-2002, will need some body parts made of stone to actually use the optimal value in a personal portfolio. Even 82% is a bit much, and the ordinary mortals may not be able to live with that.

 

Surprisingly, the solution may be quite simple: http://seekingalpha.co... .
22 Jan 2016, 10:53 PMReply2Like
 
Varan has a great, simple solution with this. I recommend this port to a lot of folks.

 

You could rebalance based on risk parity, minimum variance, or max sharpe using the free portfolio tools on ETF replay. For me, I think splitting the difference between max sharpe and minimum variance is ideal, done quarterly.

 

Once you reach about $200k, better to switch to futures, if in a taxable account.
23 Jan 2016, 03:42 AMReply2Like
 
Or simply use max sharpe and target a certain level of portfolio volatility.
23 Jan 2016, 04:33 AMReply0Like
 
You can optimize portfolio for either max sharpe or min risk at portfoliovisulaizer:

 

http://tinyurl.com/jyh...
23 Jan 2016, 08:14 AMReply0Like
 
Thanks. That is a great resource. If you pay can you optimize for shorter periods of time, such as three months?
23 Jan 2016, 09:14 AMReply0Like
 
Thanks for the great article. Most analyst are pretty negative about leveraged ETF's. It is nice to have an objective view and some explanation of what is behind.

 

I have positions in UWTI (3X crude bull) and UCO (2x crude bull). I have created scenarios of oil price recoveries for the next year using the random number generator function in Excel. Most scenarios show a gain for an oil price going from $43 to $60 in the next year. The exercise also shows what is described in this article where the gains largely depend on how it recovers. A slow steady growth is better than one with volatility.
14 Aug 2015, 02:14 PMReply0Like
 
Author’s reply »
 
Always watch closely underlying future contracts rolling costs/gains for commodity ETPs! Backwardation may make up for beta-slippage, but when the underlying is in contango, it is an additional drag.
17 Aug 2015, 02:42 PMReply2Like
 
The key thing to overcome this phenomenon is to be able to buy more when the price goes down. For me, this is the only valid reason to buy a leveraged bull security. Of course, if the security price goes down more and you don't have any more cash to put in, then you've got a problem.
19 Apr 2014, 04:31 AMReply1Like
 
What about this?: http://bit.ly/1AjLuFW
01 Jan 2015, 09:24 AMReply1Like
 
Dca is different because it's continual investment at regular intervals. What the poster is talking about is buying more of the etf only when it takes a big hit to lower your basis. This will work much better but it also means you have to be willing to buy at times when most are too afraid to buy.
19 Feb 2017, 05:29 PMReply0Like
 
So IOW, take the advice of someone like Warren Buffet; I could do that!

 

As for myself, I just just closed out part of my position on BRZU (3X Brazil), with that basis being at a price of 7 and the proceeds at a price of 52. Yes, I've had some decay in BRZU as it went down, but the last tranche purchases like this one are the ones that really hit the jackpot, and it more than makes up for the decay of the initial tranche. And as a bonus, as BRZU went down, I was able to do some Roth conversions at my 0% tax rate in 2015 (end) & 2016 (beginning) that are worth vastly more, also contributing to the net gain. That said, I wouldn't be levering up on the S&P right now as it is a high price point; levering only works when the underlying index is very undervalued.
21 Feb 2017, 10:19 AMReply0Like
 
During bull markets, leveraged ETFs have much higher returns than individual stocks with the same or higher volatility. You also have diversification, low trading commissions (you're only trading one stock that tracks a basket of stocks), no margin interest, and no margin calls. As for bear markets, a low unemployment rate (less than 4.5%) that's sharply rising and a tiny deficit (less than 3% of GDP) is a sign that the bull market has peaked and it's time to buy a leveraged inverse ETF.
08 Jan 2014, 03:00 AMReply0Like
 
".... is a sign that the bull market has peaked and it's time to buy a leveraged inverse ETF. ..."

 

It's never that easy or mechanical. Good luck
08 Jan 2014, 05:54 AMReply3Like
 
Yes, we need both for a healthy market. But I bet you to the average joes are better off with ETFs over individual stocks. Because a broadstrum leveraged ETF could cover more areas, and less susceptible to manipulation or bankruptcy.
10 Dec 2013, 08:23 AMReply1Like
 
This is actually a good point and one which traders who have lost a substantial amount of money on stock picks should consider. Rather than more risky stock picking to try and make back losses (a typical approach which usually backfires) enhance your gains by using a leveraged broad spectrum etf strategy. It's like an index fund on steroids. Reduce risk more by using a paired approach like the one suggested by V above
19 Feb 2017, 05:25 PMReply1Like
 
I always feel really strange that many, including SA contributors often have a negative sentiment toward leveraged ETFs. The beta-slippage is not wrong, however, it could not represent their overall movement. Let me repeat again, it could not! Why? Because these ETFs closely follow the movements of their original counterparts. Although they won't yield exact result (in theory), they have similar trends to the actual index. I do agree with you that playing specific sector, shorting the market (ultra short), and 3x leveraged could pose significant financial loss without certain reassurance, strategy or insurance. In fact, playing or holding leveraged ETFs (that follow broad spectrum of the market, eg: SSO) are much safer, compared to individual stocks. I guess the remain problem is if everyone puts their hard-earned money on Indexs, broad spectrum ETFs, then how MMs would charge fees, make money both way; and how much left to write, or pitch about on SA.
09 Dec 2013, 08:01 PMReply0Like
 
Author’s reply »
 
Thanks for your comment. If leveraged ETFs are better instruments than individual stocks is a pointless question. We need both because no rationale is good enough to bet all our money on it. Same paradigm as the technical analysis vs fundamental analysis (pointless) opposition.
10 Dec 2013, 07:09 AMReply0Like
 
80% draw down really isn't an issue. After you lost that much, may as well let the position ride. Most of the money is lost so selling to retain a 20% value isn't worthwhile, so let it ride. You have pretty much written it off as a total loss already, may as well let the market cycle reverse/recover. Sometimes it takes a few years, but what are you going to do with the little that is left anyway. Unlike a pure stock play, the leverage ETF's rarely go to zero. Look at the Dow, it moves the losers out and puts into new vibrant companies, so the underlying ETF may get healthy again.
05 Dec 2013, 08:44 PMReply2Like
 
Author’s reply »
 
Losing time is always a problem. Life is short.
06 Dec 2013, 06:59 AMReply2Like
 
You invest in the ETF, not in the index. So you compares the ETFs between them, not the indexes between them.

 

Why always compare to the index ?
01 Dec 2013, 08:07 PMReply0Like
 
Author’s reply »
 
I'm not sure to understand your question. If you mean S&P500 leveraged ETFs, my previous article compares them: http://bit.ly/1fYNKK6
02 Dec 2013, 06:50 AMReply0Like
 
great article, fred. why is it that SDS has a beta slippage close to 0 ?
27 Nov 2013, 12:18 PMReply0Like
 
Author’s reply »
 
Thanks for your comment. By construction the S&P500 index is not a volatile asset (a big difference with silver for example).
27 Nov 2013, 01:05 PMReply0Like
 
Would the beta slipped on my favorites DIG and DUG be large? Can the betta slippage actually be positive? DIG being much different than DUG as it holds mostly stocks and some swaps as DUG is all swaps. Not that I understand swaps very well. Thank you.
13 Apr 2014, 09:03 PMReply0Like
 
Author’s reply »
 
There is no definitive answer. During a mid-term steady trend up, beta-slippage may be positive. But on the long run it looks negative compared with an unleveraged ETF on a very close index: http://bit.ly/1eE3E7V
14 Apr 2014, 07:51 AMReply2Like
 
Yes, if you put your SSO in a lockbox ultimately you are going to get total returns that are multiple of the SPY returns. Simulated data suggests that during 1991-2013 the buy and hold approach would have returned 3 times the return of the SPY.

 

However, the over 80% drawdown that this would have entailed is something that very few mortals will be willing or able to calmly withstand.
27 Nov 2013, 09:57 AMReply4Like
 
Time and again these Decay Analysts kept failing to understand the power of COMPOUNDING.

 

Albert Einstein declared that Compounding is the MOST powerful force on earth. Not Decay.

 

- SSO gained 588% from the March 2009 bottom,

 

- SnP500 gained 170%;

 

Therefore SSO is performing as if it is actually a 3.46x ETF instead of a 2x ETF.

 

That's the power of compounding despite the 17.19%, 21.53%, and 10.90% corrections SnP500 suffered in 2010, 2011, and 2012 respectively.

 

* I started investing in SSO (and FAS) since August 2009 in expectation that compounding, on rallies, will trounce all other negative aspects of leveraged ETFs.

 

Statistically speaking, the stock markets rally 66% of the time over a very long period of time.

 

Buy Low - Sell High.
27 Nov 2013, 09:16 AMReply4Like
 
Author’s reply »
 
Thanks for your comment. Compounding is a money management choice. Someone who is trading for an income stream takes his/her benefits out on a regular (or irregular) basis and doesn't compound.
27 Nov 2013, 12:54 PMReply2Like
 
Let me know how that works out when 2008 or 1987 or 1973-74 come around again.
24 Jun 2017, 05:13 PMReply0Like
 
AQRIX uses a "risk parity" approach, but has had mediocre results so far.
26 Nov 2013, 06:42 PMReply2Like
 
You have to do it right - either with the right basket as in SSO/UBT above, or with some smart modifications of the risk parity approach. If you just use plain vanilla risk parity with a bunch of equity and fixed income funds as they and many others seem to be doing, the return component of the performance will be dominated by the returns of the fixed income assets and therefore will tank in years like 2013. For example, simple quarterly update of VFINX/VUSTX (SP500 and long term treasury) overall did quite well for 1991-2013, yielding market level returns with only two years of annual losses (0.6% and 2.6%), and with much lower volatility, but returned only 7% this year.
26 Nov 2013, 07:47 PMReply3Like
 
If you have a portfolio of SSO and UBT that you rebalance every quarter by using risk parity on the basis of the daily return data from the previous quarter, you can do very well.

 

Surprisingly, on the basis of simulated data for years prior to 2011, even the drawdown is comparable to the drawdown of many balanced funds (actually better than all of DODBX, FBALX, FGBLX, VBIAX, WFAIX, VWELX and SWOBX, but only slightly worse than the drawdown of VWINX - 25% vs. 19%). Of course the return is pretty good: the respectable 19.6% with only three years of annual losses (-6% in 1994, -1.3% in 2001, and -0.8% in 2008).

 

This is almost free money with at most one hour of work every year.
26 Nov 2013, 02:56 PMReply7Like
 
Author’s reply »
 
Varan,
Thanks a lot for the insights.
26 Nov 2013, 03:13 PMReply0Like
 
I would like to test the validity of SSO/UBT claim. Where do you get the correlation and raw data on these two assets?
27 Nov 2013, 07:31 PMReply1Like
 
Varan, what is the allocation mix (risk parity) for that SSO and UBT pair.?? Is it the traditional 60/40 and then a rebalance every quarter. Or is it 50/50 ??
29 Nov 2013, 06:57 AMReply1Like
 
fred where is your dashboard of decay? What is it for TVIX july?
19 Jul 2016, 07:34 PMReply0Like
 
Author’s reply »
 
It is here: http://seekingalpha.co...
VIX ETPs are not in this dashboard.
31 Jul 2016, 09:23 PMReply0Like
 
I don't see VIX..ETN...LIKE TVIX is what i was curious about.
@ $4.92 as soon as we see d
sp500 20% pullback tvix..will spike..but I want a simple explanation how to take the leading front months and figure decay even though it moves forward toward its expiration..can you send me your email to explain please..
regards
p.n.
 
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