Flushing returns down the volatility drain with Leveraged and Inverse ETFs: part 2

This week, I will follow up on a blog from several months ago in which I discussed how volatility can destroy returns in leveraged ETFs. I received several comments on that blog and continue to see articles written about leveraged ETFs in various publications so I thought the time was right for a continuation. The crux of the original blog was that compounding kills performance, particularly in times of high volatility, such that the long-term returns of leveraged ETFs are actually quite unpredictable. They meet their objective over the short horizon, like intra-day or one day, but multiplying the long-, mid-, or even near-term performance of the index by 2 or 3 (or -1, -2, or -3 for inverse ETFs) does not produce an accurate estimate of the performance of the leveraged ETFs over that same time period.

This week I will add some empirical data to the analysis. But first a pop quiz.

Listed below are the names and one-year returns of the Russell 2000 along with the ProShares 2x, inverse 1x, and inverse 2x Russell 2000 ETFs. Can you match each security to its return?

Read on for the answers.

1) ProShares UltraShort Russell 2000 ETF (Inverse 2x)
2) ProShares Ultra Russell 2000 ETF (2x)
3) Russell 2000 Index
4) ProShares Short Russell 2000 ETF (Inverse 1x)

a) -62.3%
b) -31.4%
c) 1.9%
d) 14.1%

The Russell 2000 is up 14.1% over the past one year (#3 goes with d). Does it surprise you that the 2x ETF is up only 1.9% over the same period? That 2x ETF returned about 1/7 of the performance of the underlying index! The inverse 1x returned -31.4% while the inverse 2x returned -62.3% which equates to over four times the inverse return of the index! Were these ETFs managed poorly?

To test, we need to look at the daily returns of the Russell 2000 and multiply each day’s return by the leverage factor of each ETF. Then, we can compound the adjusted daily returns. The Russell 2000 index itself is up 14.1% over the last year. Assuming perfect daily replication of 2x the index, the return would be 3.7% over the same period compared to the 1.9% returned by the 2x ETF. Perfectly replicating the -1x inverse index and -2x inverse index each day would return -29.9% and -60.8% respectively, approximately 1.5% higher than the equivalent ETF. It is much more the case that compounding in a very volatile market led to the seemingly poor performance rather than poor management of the funds.

In fact, that period was one of the most volatile periods in the last 20 years, with a 2.98% daily standard deviation of the Russell 2000. How big an effect can volatility have on leveraged and inverse ETF performance? Let’s take a look at another period.

1995 was a year of particularly low volatility. The daily standard deviation of the Russell 2000 that year was only 0.51%. Of course there were no leveraged or inverse ETFs back then, but we can approximate by multiplying each days return by the leverage ratios and compounding. The Russell 2000 returned 28.45% in 1995. The returns of the hypothetical ETFs from that time are shown below. In all five cases, the returns of the leveraged ETFs are higher than expected by multiplying the full year Russell 2000 return by the leverage ratio.

The tests run for the S&P 500 ETFs returned very similar results. The one year performance data for all ETFs tested are below.

Not surprisingly, the 1x ETFs performed almost exactly as expected over the year since daily volatility has no affect on long term replication in this case. These are the only ETFs that should be considered for long-term inclusion in one's portfolio. Leveraged and inverse ETFs do have their place for short-term hedging and other very short-term strategies, but not for the long-term investor.

You should consider your rationale and time frame for investing in these assets. Investors do seem to understand this point, as trading activity (average daily volume divided by shares outstanding) is considerably higher for the more highly levered ETFs.

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