Summary
- What is decay?
- Our ETF drift watch list.
- The worst and the best of ETF drifts.
- This idea was discussed in more depth with members of my private investing community, Quantitative Risk & Value. Get started today »
I measure once a month the decay of major leveraged ETFs. It may be useful for anyone using leveraged ETFs for investing, trading or hedging.
Where does the decay come from?
Leveraged ETFs often underperform their underlying indexes leveraged by the same factor. This relative decay has several reasons: beta-slippage, roll yield, tracking errors, management fees. Roll yield may be prominent for commodity ETFs, but beta-slippage is usually the main source of decay. However, it doesn’t always result in decay. When an asset is trending with little volatility, a leveraged ETF can bring an excess return over the leveraged asset. You can click here to learn more about beta-slippage and examples.
Monthly and Yearly Drifts
A few simple formulas and data definitions are necessary before going to the point. “Lev” is the leveraging factor. “Return” is the total return of an ETF (including dividends). “IndexReturn” is the total return of the underlying index, measured on a non-leveraged ETF (also with dividends). “ETFdrift” is the drift of the ETF relative to the leveraged index. “TradeDrift” is the drift relative to an equivalent position in the non-leveraged index. ETFdrift and TradeDrift are calculated as followed, where Abs is the absolute value operator.
ETFdrift = Return - (IndexReturn x Lev)
TradeDrift = ETFdrift / Abs(Lev.)
“Decay” is negative drift. “Month” stands for 21 trading days, “year” for 252 trading days.
A drift is a difference between 2 returns, so it can be below -100%.
BDCL and TVIX are exchange-traded notes. ETNs entail additional counterparty risks.
In 1 month:
- The leveraged ETFs in real estate (DRN) and biotechnology (LABU) have the worst monthly decays with a drift of -0.4% normalized to 1x the underlying indexes exposure.
- The highest positive monthly drift is in the inverse leveraged semiconductors ETF (SOXS), with a drift of +2.1% normalized to 1x the underlying index exposure, in a large loss due to a rally in this industry.
In 1 year:
- The worst decay is in the leveraged biotechnology ETF (LABU) with a normalized drift of -8.1%.
- The highest positive drift is for the inverse leveraged ETF in semiconductors (SOXS) with a normalized drift of +36.6% in an asymptotic loss pattern. Leveraged ETFs in volatility (TVIX), long semiconductors (SOXL), inverse Nasdaq 100 (SQQQ), inverse S&P 500 (SPXU), inverse gold miners (DUST), inverse real estate (DRV) have all 2-digit positive drifts in large losses due to a strong year for the underlying indexes.
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