Most investors are wary of leveraged ETFs because of their decay, but few understand it. You can read this article published in 2013. Here is a summary before going to the point.
Leveraged ETFs decay in a few words
If a volatile asset goes up 25% one day and down 20% the day after, a perfect 2x 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. At the same time, the perfect leveraged ETF has lost 10%:
(1 + 0.5) x (1 - 0.4) = 0.9
The decay is not always one. It can be a gain in a bullish trend. If an asset goes up 20% two days in a row, on the second day it is up 44%. The 2x ETF is up 96%, which is 8% better than twice the underlying asset return:
(1 + 0.4) x (1 + 0.4) = 1.96
The decay 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 of beta-slippage: "beta" is a statistical measure of volatility. However, it is a bit misleading because the decay cannot be calculated from beta. These numbers give an amplified vision of what happens with more realistic daily returns, day after day and month after month. There are other sources of decay: management fees, tracking errors, underlying derivatives (future rollover costs, option decay). Beta-slippage is the major one for stock index ETFs.
Decay and hedging cost in 2016
Hereafter, hedging a stock portfolio means taking a short exposure to the benchmark (S&P 500 index). A full hedge is an exposure equivalent to 100% of the portfolio value.
The next chart shows a step-by-step calculation of the real cost of a permanent and full stock portfolio hedge from 1/1/2016 to 5/12/2016 with the best known S&P 500 ETFs.
Lev. | Ticker | Return | SPY x leverage | Decay | Decay/ Equity | Borrowing rate | Borrowing cost | Hedging cost |
1 | 3.53% | 3.53% | 0.00% | 0.00% | 7.15% | 2.57% | 2.57% | |
2 | 5.85% | 7.06% | -1.21% | -0.61% | 2.22% | 0.40% | -0.21% | |
3 | 7.51% | 10.59% | -3.08% | -1.03% | 4.35% | 0.52% | -0.50% | |
-1 | -4.40% | -3.53% | -0.87% | -0.87% | 1.87% | 0.67% | 1.54% | |
-2 | -9.45% | -7.06% | -2.39% | -1.20% | 1.87% | 0.34% | 1.53% | |
-3 | -14.80% | -10.59% | -4.21% | -1.40% | 1.87% | 0.22% | 1.63% |
It needs some explanations:
Lev: Leveraging factor
ETF decay: difference between ETF return and theoretical return (SPY return multiplied by the leveraging factor). Dividend yield is taken into account when there is one.
Decay/Equity: ETF decay divided by the leveraging factor. It is the column to compare decays for the same market exposure. It also gives the decay in % of the stock portfolio value to hedge. Example: SPXU position size is 1/3 of the portfolio value to hedge, so the decay adjusted in % of the portfolio value is 1/3 of the ETF decay.
Borrowing rate: for a long ETF, it is the annual rate for borrowing and selling it short. For an inverse ETF, it is the annual rate to buy on margin. Rates are from Interactive Brokers (NASDAQ:IBKR) rate optimizer on 5/12/2016.
Borrowing cost: the previous rate multiplied by the fraction of year and the fraction of the stock portfolio value needed as hedging position (1/3 for triple ETFs, 1/2 for double ones, 1 for simple ones). It is the cost of borrowing money or tickers for hedging, in percentage of the stock portfolio value.
Hedging cost: the combination of borrowing and decay in percentage of the stock portfolio value. For inverse ETFs, decay is a cost. For long ETFs sold short, it is a gain.
Interpretation
Due to an excessive cost of borrowing and shorting SPY, all alternatives are currently better.
Among inverse ETFs, the leveraging factor has little effect on the hedging cost.
For investors who cannot or don't want to sell short, SDS and SPXU are acceptable solutions, but expensive for a full and permanent hedge. The annualized cost is above 4% of the hedged equity value. This is why I propose scaled hedging tactics based on a multivalued risk indicator.
Shorting SSO and UPRO can bring an excess return, with an additional risk: shares can be called back at any time by the broker. It is unlikely for these tickers in usual market conditions, but shares may become momentarily unavailable if everyone sells in panic. In a crash, it may be necessary to switch to SDS or SPXU before closing if an alert comes (or to anticipate it). Borrowing rates must be monitored closely. Unlike the margin rate, they may change often in large proportions and transform a good idea in a bad one.
Futures are also good for hedging, but less scalable. A short position has a rollover cost when contracts are in backwardation like now (about 1% annualized when I write this). It becomes a gain in contango times. Option strategies have a less predictable tracking error in following the benchmark.
Statistics presented here are on a past period of a few months with data from IB. Some factors may change the conclusion:
- Margin rates are much higher at most brokers. Borrowing rates may also be different.
- Higher volatility would increase the hedging cost of SPXU / SDS, and the gain for SSO / UPRO.
- A rate hike by the FOMC would increase borrowing costs in all cases, possibly in different proportions.
I have the idea of a monthly Decay Dashboard series updating decays of the most liquid leveraged ETFs in stock indices, bonds, gold, silver, and oil. If you like it, please let a comment below and click "follow" at the top of this article.
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.