Hedged In

A Skeptic on Leveraged ETFs

Tracking error of leveraged ETFs relative to their underlying indexes depends what time period you're using. The 2x leveraged ETFs are supposed to deliver 2x the *daily* performance of the underlying index; that means that over longer periods of time their performance won't be 2x the underlying index.

This works to your advantage if the underlying index moves strongly in your favor. For example, when the market dived over a period of a few weeks, the 2x inverse ETFs were massively more profitable than shorting the plain index ETFs.

Here's what happens if the underlying index drops 3% every day for 10 days. The first column shows the value of the underlying index and thus a regular ETF; the second column shows what happens to a 2x inverse ETF tracking that index:

100 100
97 106
94 112
91 119
89 126
86 134
83 142
81 150
78 159
76 169

The underlying index is down from 100 to 76 -- a 24% decline. But the double inverse ETF is up 69%.

But now look what happens if the index goes nowhere over a 50 day period, up 3% one day, down 3% the next:

100 100
103 94
100 100
103 94
100 99
103 93
.
.
.
98 92
101 87
98 92
101 86

Over a 50 day period, the underlying index is up 1%, but the double inverse ETF is down a massive 14%.

Bottom line: Leveraged ETFs are great for sharp market moves, but do really badly if the market is broadly flat but with volatility.

Together with the other disadvantages pointed out in the article (the cost of rolling over futures etc.), this also makes them great for short term trading, and bad for long term investing.