Academic journal article Financial Services Review

Long Term Performance of Leveraged ETFs

Academic journal article Financial Services Review

Long Term Performance of Leveraged ETFs

Article excerpt

Abstract

In this article, we study leveraged ETFs, in particular, Ultra ETFs and Ultrashort ETFs from the ProShares family. These Ultra (Ultrashort) ETFs are designed to provide twice (twice the opposite) of the performance of the benchmark on a daily basis. We focus on the relation between long term performance of leveraged ETFs and benchmarks. Our results show that over holding periods no greater than one month, an investor can safely assume that the Ultra (Ultrashort) ETF would provide twice the return (twice the negative return) of the underlying benchmark. Over the holding period of one quarter, the Ultrashort ETFs can deviate from twice the negative returns of the benchmark. For Ultra ETFs, this deviation occurs when the holding period is one year. Finally, we show that the long term performance of the leveraged ETFs is negatively impacted by the quadratic variation and the auto-variation during the period, with auto-variation being the more dominant factor. © 2012 Academy of Financial Services. All rights reserved.

JEL classifications: G1

Keywords: Leveraged ETFs; Bootstrapping

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Leveraged Exchange Traded Funds (ETFs) are designed to provide more than 100% of the exposure of the benchmark. Since July 2006, ProShares has launched a series of Ultra ETFs and Ultrashort ETFs. The Ultra ETFs are designed to double the daily returns of the underlying index while the Ultrashort ETFs are designed to provide twice the inverse performance of the underlying index on a daily basis. These leveraged ETFs become popular trading instruments and their daily trading volumes are quite high.1 In November 2008, Direxion even introduces triple leveraged ETFs and these triple ETFs immediately gain acceptance from the market.

Given the large trading volumes of these leveraged ETFs, it is tempting to use them as part of the investment portfolio. While the focus of these ETFs is to double or triple the daily movement of the benchmark, for a long term investor, it is crucial to understand the long term performance of these leveraged ETFs. Do they deliver the same times of the long term performance of the benchmark? If the answer is yes, then an investor may gain the same long term exposure as holding the benchmark by holding a small amount of the leveraged ETFs. Furthermore, if an investor wants to make a long-term bet against a benchmark, he or she may use the inverse leveraged ETFs without engaging in any short selling activities. However, there is some anecdotal evidence that the long term performance of leveraged ETFs may be problematic. Lauricella writes in his Wall Street Journal article2:

Many of these funds promise to deliver twice the return of an underlying stock or bond index, or move twice as much in the opposite direction. So with the Standard & Poor's (S&P) 500-stock index down 38.5% in 2008, a double-leveraged fund designed to profit when the S&P 500 falls would be up 77%, right? Wrong. The Ultrashort S&P500 ProShares rose 61 %. Even more confusing, the ProShares fund designed to return twice the opposite of the Dow Jones U.S. Real Estate Index was down 50% for 2008, while the index was also down, by 43%.

Note that this discrepancy in the expectation of the long-term performance of the leveraged ETFs is not a flaw in the design. It is more a result of the misperception of the investors. Actually, ProShares in its own document "Understanding ProShare's Long Term Performance" states that:

In the end, ProShares ETFs are designed to accomplish their objectives on a daily basis. As a result, you shouldn't expect ProShares to provide 200%, -200%, or -100% of index performance over longer periods.

However, the ProShares document and other comments in blogs and newspapers only contain a warning about the long term performance of leveraged ETFs, they do not address the issue of how leveraged ETFs perform against the benchmarks over longer periods since the inception. …

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