Understanding Leveraged ETFs

What is Volatility Decay?

Volatility decay (also called beta slippage) is a mathematical phenomenon that affects all ETFs, not just leveraged ones. It occurs due to the compounding of returns, where the sequence of returns matters more than the average return. Leverage simply amplifies this effect.

For example, consider a regular unleveraged ETF that goes up 25% one day and down 20% the next:
• Day 1: 100$ → 125$ (up 25%)
• Day 2: 125$ → 100$ (down 20%)
Despite the average return being +2.5% ((25% - 20%)/2), you end up exactly where you started!

This effect is dramatically amplified with leverage. Here's a 2x leveraged ETF with ±10% underlying moves for five days:

  • Day 1: 2 × 10% = 20% gain → 120$
  • Day 2: 2 × -10% = -20% loss → 96$
  • Day 3: 2 × 10% = 20% gain → 115.20$
  • Day 4: 2 × -10% = -20% loss → 92.16$
  • Day 5: 2 × 10% = 20% gain → 110.59$

The underlying index ends at 99$ (1% loss), while the 2x leveraged version is at 110.59$ (-10.59% vs expected -2%). This increased impact of volatility decay is why leveraged ETFs are generally not recommended for long-term "buy and hold" strategies in volatile markets.

Understanding Leverage Expansion

While leverage decay is often discussed as a negative aspect, the same mathematical principle can work in your favor during trending markets - this is called leverage expansion.

In a consistently trending market with 5% daily gains for five days:

  • Day 1: 2 × 5% = 10% gain → 110$
  • Day 2: 2 × 5% = 10% gain → 121$
  • Day 3: 2 × 5% = 10% gain → 133.10$
  • Day 4: 2 × 5% = 10% gain → 146.41$
  • Day 5: 2 × 5% = 10% gain → 161.05$

The underlying index would only be at 127.63$ (27.63% gain). This positive difference of 33.42% is leverage expansion, demonstrating how leveraged ETFs can outperform in trending markets.

Hidden Costs beyond TER

While the Total Expense Ratio (TER) is the most visible cost, leveraged ETFs incur several additional expenses that aren't immediately apparent:

  • Swap costs for derivative contracts (0.3-0.5% annually)
  • Interest on borrowed money (3-5% annually)
  • Transaction costs from daily rebalancing (0.5-1% annually)
  • Bid-ask spread costs (varies by liquidity)
  • Market impact costs from large trades

Adding these costs together, one might expect total costs of 5-8% annually for a 2x leveraged ETF. However, the actual tracking difference is often only 2-3%.

How Providers Keep Costs Low

ETF providers employ sophisticated strategies to minimize these costs:

Trading Optimization

  • Netting of positions across funds
  • Smart rebalancing thresholds
  • Internal trade crossing
  • Economies of scale in trading

Financial Engineering

  • Competitive swap agreements
  • Strategic use of futures vs swaps
  • Tax-efficient rebalancing
  • Portfolio optimization techniques