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Alpay Kaya
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My professional background is in algorithmic proprietary trading with a basis in quantitative research. Having led systematic strategy research efforts in both Fortune 500 and start-up hedge fund enterprises, my experience spans asset classes and instruments. Like many others, I came to the... More
My blog:
Alpay Kaya, CFA
My book:
The Value in Volatility: A Practitioner's Guide to Leveraged ETFs
  • LETF Negative Drift: Not A Mis-Pricing 0 comments
    Apr 7, 2013 11:34 PM

    A reader of my recent SA article on the difference between deterministic and statistical notions of drift, as it relates to LETFs, sent me the following question. I am sharing it because others may also be conceptualizing LETF drift as a mis-pricing.

    From reading numerous articles about LETFs, they all seem to say there's a negative drift to both the bullish and the bearish LETFs. So why don't the professionals just short them both and cash in on the drift. Of course if enough of them did that, wouldn't it cancel out the negative drift?

    As I mentioned in the article, LETFs are subject to negative drift. It is for this reason I wrote the article. Since many do not understand the statistics of "garden variety" assets (geometric Brownian motion) they are not in a position to understand the implications of the statistical claim made in the blog I referenced. All of the math needed to understand this is reviewed step-by-step in my book Leveraged ETFs, beginning with the definition of return.

    On to your question about shorting and canceling out negative drift. Managed with rebalancing, shorting LETF pairs is profitable over time, which is probably why individual investors are posting complaints all over the web about how difficult it is to find pairs to borrow! Also, negative drift is a function of these funds' constant-leverage/variable-delta nature, which itself is function of the daily rebalancing. Regardless of how the index moves, it does not get canceled out as an arbitraged mis-pricing would.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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