Dynamics of ETF vs. Leveraged ETF spreads

Author: Ganapathy Vidyamurthy | 10/18/2011

By nature of their design the Leveraged ETFs and inverse leveraged ETFs are primarily used for short term speculation or as a portfolio hedge. This intentional design of the ETF however has ramifications when the Leveraged-ETFs are held for longer periods of time. As a matter of fact, it is well understood that leveraged ETFs tend to underperform the non –leveraged ETFs over longer periods. We examine this phenomenon to see if this underperformance can be consistently and systematically captured.

Background

Basic Equation

The dynamics of leveraged ETFs and their performance have been well studied in [1], [2].
The key result in the studies is the equation that relates the return of the ETF to the return of the leveraged ETF as a function of the realized volatility.

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