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The Properties of Short Term Investing in Leveraged ETFs

Journal 35: Zicklin-Capco Institute Paper Series in Applied Finance

Geng Deng, Craig McCann

In this paper, we model tracking errors of LETFs compared to a leveraged investment in discrete time. For a period lasting a month or less, the continuous time model predicts tracking errors to be small. However, we find that in a discrete time model, daily portfolio rebalancing introduces tracking errors that are not captured in the continuous time framework. On average, portfolio rebalancing accounts for approximately 25% of the total tracking error, and in certain scenarios the rebalancing tracking error could rise to as high as 5% in three weeks and can dominate the total tracking error. Since investors in LETFs have short average holding periods and high average turnover ratios, the effects of portfolio rebalancing must be accurately accounted for in the analysis of LETF returns.

The daily returns on leveraged and inverse-leveraged exchange-traded funds (LETFs) are a multiple of the daily returns of a reference index. Because LETFs rebalance their leverage daily, their holding period returns can deviate substantially from the returns of a leveraged investment. While about half of LETF investors hold their investments for less than a month, the standard analysis of these investments uses a continuous time framework that is not appropriate for analyzing short holding periods, so the true effect of this daily rebalancing has not been properly ascertained.

Exchange Traded Funds (ETFs) were introduced in the U.S. markets in 1993 and their number has grown rapidly ever since. By the end of January 2011 there were 943 ETFs with combined assets of more than $1 trillion. Originally, ETFs tracked broad-market indexes such as the S&P 500 index. More recently, ETFs with more complicated exposures to underlying assets and more complex investment strategies have been issued. For example, the daily return on the leveraged “Ultra S&P 500 ProShares” (SSO) is twice the daily return of the S&P 500 Index. Leveraged and Inverse ETFs (LETFs) were first issued in the United States in June 2006 by the ProFunds Group; there are now more than 400 LETFs with combined assets of more than $120 billion.

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