Leveraged ETFs- a market inefficiency

Here’s how the inefficiency works.  Every day, leveraged ETFs have to trade to maintain a constant level of leverage.  The transaction costs of trading every day is very high since they often trade illiquid derivatives or swaps.  It’s not like they trade liquid products such as S&P 500 futures.  In a year with high volatility, a leveraged ETF could lose 20% of its net asset value to transaction costs.

One way to play this inefficiency is to short both the bull and bear versions of a leveraged ETF.  If you want, you could also rebalance the ETFs frequently so that you have no risk from a trending market.  (In a trending market, one ETF might go up several times while the other goes down close to 0.)  Unfortunately, many people seem to have caught on to this trade as leveraged ETFs frequently have borrow costs in the mid single digits.

I personally do not recommend this arbitrage trade… the risk/reward does not seem compelling to me considering the borrow costs.

4 thoughts on “Leveraged ETFs- a market inefficiency

  1. over time these double/triple leveraged etfs are going to decay more than a mid single digits costs though and they are not difficult to trade around to add more to the p&l. some of the commodity etfs are even worse given the steepness of the curve too, vxx is a classic.

    • Hi Shaun, thanks for the comment. In a range-bound market with excess volatility, the rebalancing will cause these ETFs to constantly buy high and sell low. But in trending markets that go one direction for a long period of time… these ETFs can go up several times. So you really need to be careful about shorting them. I think shorting these ETFs is an ok/good trade, but shorting is rarely as easy as it looks. And in rare cases, ETFs can trade well above their NAV. UNG is a great example… the creation units feature was suspended and the shorts got squeezed.

      Maybe there is a seductive trade in shorting a diversified basket of both the bull and bear leveraged ETFs. Most of the time it will have a strong positive carry… it’s the kind of trade that the LTCMs of the world would put on. Tail risk can be nasty.

  2. Go to etfreplay.com and enter a portfolio of SSO 50%, TIP 50% and compare that to 100% SPY for any single year and you’ll generally see relatively low tracking error.

    • I don’t think that is a reasonable proxy for tracking. TIP is an ETF for inflation-protected treasuries… it is not the same as the “risk-free” interest rate.

      To figure out the amount of money lost from transaction costs, you have to build a spreadsheet because you need to make daily calculations to account for re-balancing of the 2X/3X index or ETF.

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