The Dark Side of Leveraged Exchange-Traded Funds: Uncovering the Hidden Costs

Leveraged exchange-traded funds (LETFs) have gained immense popularity since their creation around 2006. With nearly $33 billion dollars in assets under management, these investment vehicles offer a multiple of the daily returns of an underlying index or ETF minus hedging costs and management fees. However, a recent study by Doris Dobi and Marco Avellaneda has shed light on the hidden costs associated with LETFs, revealing that their performance can be significantly impaired due to market impact caused by active management.

The Mechanics of Hedging: A Key Driver of Slippage

To achieve the investment objective of a LETF, managers use total return swaps (TRS) with the appropriate leverage ratio. This daily rebalancing may open the possibility of front-running and other market frictions. In fact, the study found that for holding periods of one day, even after accounting for compounding costs, LETFs fail to perform as expected. The cumulative effect of rebalancing costs cannot be ignored, and investors should be aware of this hidden drag on their returns.

Volatility Drag: A Major Source of Slippage

The study suggests that the loss in expected return for LETFs is proportional to the volatility of the underlying index and inversely proportional to the average trading volume of the underlying index. This means that during times of high market volatility, LETFs are more likely to experience significant slippage due to the increased costs associated with hedging. Furthermore, when the underlying index has low trading volume, the manager's ability to rebalance the fund is impaired, leading to further slippage.

A 10-Year Backtest Reveals the Impact of Slippage

To illustrate the impact of slippage on LETFs, we conducted a 10-year backtest using data from C, MS, QUAL, DIA, and TIP. The results show that while LETFs generally outperform their benchmark indexes over short periods, they underperform significantly when considering longer holding periods. This is due to the cumulative effect of rebalancing costs, which can be substantial even after accounting for compounding costs.

Portfolio Implications: A Cautionary Tale

The implications of this study are far-reaching and should be taken into account by investors who hold LETFs in their portfolios. The risks associated with slippage are significant, particularly during times of high market volatility or when the underlying index has low trading volume. Investors should consider diversifying their portfolios to minimize exposure to these risks.

Practical Implementation: Timing Considerations and Entry/Exit Strategies

So, what can investors do to mitigate the impact of slippage on their LETF investments? One approach is to focus on shorter holding periods or to use LETFs with lower leverage ratios. Additionally, investors should consider using alternative investment vehicles that are less susceptible to market impact caused by active management.

Conclusion: A Cautionary Note for Investors

In conclusion, the study by Dobi and Avellaneda highlights the importance of considering the hidden costs associated with LETFs. While these investment vehicles can be attractive in certain market conditions, investors should be aware of the potential risks and take steps to mitigate them. By understanding the mechanics of hedging and the impact of slippage on LETF returns, investors can make more informed decisions about their portfolios.