Dangers of Volatility Decay

(Or why Leveraged ETF’s are not a magic bullet!)

Volatility decay, also known as "leverage decay" or "beta slippage," is a phenomenon that impacts the performance of leveraged ETFs due to their daily rebalancing. Let's explore a detailed example of volatility decay in a 3x leveraged ETF. Note the huge gap in performance in the next two charts. QQQ 3x is a mathematical perfect 3x of NASDAQ, while TQQQ is the real 3x leveraged ETF. Same with SPY a perfect 3x SP500 ETF and the 3x UPRO ETF.

Lets Figure Out Why

Suppose we have a hypothetical index, "Index A," and a 3x leveraged ETF that tracks this index, called "Leveraged ETF A." Let's assume that Index A starts at a value of $100, and Leveraged ETF A starts with a share price of $100.

At the end of Day 2, Index A has returned to its original value of $100. However, Leveraged ETF A has declined from its initial share price of $100 to $94.55, a loss of 5.45% that Index A does not share. This loss is due to volatility decay.

The daily rebalancing of leveraged ETFs causes this decay, as the compounding of daily returns does not always translate into the expected return values over longer periods. In our example, even though Index A has not changed in value, Leveraged ETF A has suffered a loss due to the compounding effect of its daily 3x leverage.

It's important to note that volatility decay has a more significant impact on leveraged ETFs with higher leverage ratios, such as 3x, and during periods of high market volatility. This is why long-term investors should be cautious when investing in high-leverage ETFs, as the impact of volatility decay can erode returns over time.

But Wait There's More :(

In addition to the impact of volatility decay, as demonstrated in the example above, the performance of leveraged ETFs can also be eroded over time by management fees and borrowing costs. Let's explore how these factors further affect the performance of Leveraged ETF A.

Management fees (also known as expense ratios) are charged by the ETF provider to cover the costs of managing and operating the fund. These fees are typically expressed as a percentage of the fund's net assets and are deducted from the fund's value daily.

Borrowing costs are incurred by leveraged ETFs because they use financial instruments like derivatives and borrowed funds to achieve their leveraged exposure. These costs can vary depending on market conditions and the specific instruments used.

Let's assume that Leveraged ETF A has an annual management fee of 1% and annual borrowing costs of 0.5%. Over the two days in our example, these fees and costs would have a small but noticeable impact on the performance of Leveraged ETF A.

At the end of Day 2, Index A has returned to its original value of $100. However, Leveraged ETF A has declined from its initial share price of $100 to approximately $94.08, a loss of 5.92%. This loss is a result of both volatility decay and the combined impact of management fees and borrowing costs. This decay is done daily it does not stop. This is why many will rightly say holding leveraged ETFs long term can cause poor performance.

Leverage investments are not a magic bullet
You should completely understand the risks and how they behave before investing

Here we zoom in even more and you can see the 3x leveraged ETF's are actually loosing to the unleveraged ETFs

Wait why is 1.5x worse then 2x?

The reason 1.5x leverage is lower than 2x leverage at the end of day 5 lies in how leveraged ETFs function. They amplify the daily returns of the underlying index; however, this amplification can also increase the effects of daily volatility, causing a phenomenon known as "volatility decay" or "beta slippage".

In essence, when an investment goes up and down frequently, leveraged returns won't match the exact multiple of the index's returns over longer periods. This is especially true when markets are volatile.

In the table, even though the underlying index (Index A) returned to its original level ($100 to $110 and back to $100), the leveraged ETFs did not. This is because the losses incurred when the market goes down are harder to recover from. If an investment loses 50% of its value, it must gain 100% to break even.

Looking at Day 5, after a series of ups and downs, the index went up again by 10%. The 1.5x leveraged ETF therefore increased by 15%, the 2x by 20% and the 3x by 30%. However, these increases were applied to the "depressed" values of the leveraged ETFs from Day 4, which were lower due to the effects of volatility decay.

Even though the 1.5x leveraged ETF experiences less volatility decay than the 2x and 3x, it also captures less of the index's gains when the index goes up. That's why it ends up lower than the 2x leveraged ETF at the end of Day 5.

In short, higher leverage can lead to higher returns during a consistent upswing, but it can also lead to more significant losses during periods of high volatility. That's why it's crucial to consider the risk associated with leveraged ETFs. It's not merely a matter of two times or three times the return of the underlying index.

TL;DR: While leveraged ETFs have historically outperformed their base index, their performance can be highly volatile in the short term, and a bear market can potentially erase years of gains in a matter of days or months.

TL;DR: Over the past 12 years, leveraged index ETFs have demonstrated strong performance when held long term, even considering the impact of the recent bear market. In good times, their returns can be extraordinarily high.

Conculsion:

Over longer periods, these fees and costs can have a more significant impact on the performance of leveraged ETFs. This is why investors should be cautious when investing in high-leverage ETFs for the long term, as the combined effects of volatility decay, management fees, and borrowing costs can erode returns over time.

We leave you with the final warning. Below is a chart with how much an Stock/ETF/Mutual Fund (Leveraged or Not) needs to recover once it has fallen. This is not meant to scare you from investing, but it must be shown.