ETF Complete Strategy Insights: The Ins and Outs of Leveraged ETFs (Part 4)

James Kimball | October 27, 2019

The ETF Complete model closed the week up +2.5% compared to the SPY which closed up +1.2%.

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This Week's Strategy Lesson: The Ins and Outs of Leveraged ETFs (Part 4)

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This week we are going to wrap up this series on leveraged ETFs. We will start by reviewing how decay arises in leveraged ETFs. Then we cover some of the other causes of decay or divergence from the indexes or instruments that ETFs try to track.

Decay in Leveraged ETFs

As we saw in the previous articles, leveraged ETFs can suffer from various forms and amounts of decay depending on market conditions. The decay is introduced by the combination of daily rebalancing along with some interesting quirks in how the math behind percentage gains and losses works.

The percentage “gain” needed to offset a percentage “loss” is not constant. A 1% loss needs to gain back 1.01% to get back to break even (an additional gain of 0.01%). A 10% loss needs to gain back 11.11% to get back to break even (1.11% additional). A 20% loss needs to gain 25% to get back to even (5.0% additional).

We see that the amount of additional gain to offset the loss increases at a fast-increasing rate. The numbers can get quite absurd when dealing with larger losses. A 1% loss only needs an additional 0.01% extra gain to offset the loss but by the time we reach a 99% loss, you need an additional 9801% extra gain to get back to even.

The daily rebalancing you see in most leveraged ETFs doesn’t sufficiently account for this difference, which can cause decay over time, which is particularly noticeable in flat markets. A 10% decline requires 11.11% increase. A simple 2x multiple would show a 20% decline with a 22.22% increase, short of the 25% needed to get back to even.

The three factors affecting the decay are the amount of leverage, the amount of volatility, and the number of periods. Larger amounts of any of these will increase the decay. In trending markets, the positive effects of compounding can more than offset any decay from the volatility and leverage (shown in part 2 & 3).

Decay in Commodity/Futures-based ETFs

ETFs that are based on futures can suffer from their own form of decay not related to leverage due to having to continually rollover their futures contracts to the next one.

A futures contract involves the promise to deliver something on a set date in the future. They are often used for agricultural and other commodities. These contracts are typically for physical items that have real storage and transportation costs attached to them (called “cost of carry”).

Imagine you had a supply of gold being stored at a self-storage facility. Every month you pay out a small storage fee. Regardless of the price of gold, at the end of the year, you would still be out the storage costs.

The situation is very similar for ETFs based on futures contracts. In normal markets, there is usually a small cost to rolling out the contracts to future months. There are additional complications like interest rates and time decay and in some circumstances these costs can be reversed (backwardation), but for the most part we see positive costs for commodity and futures ETFs.

This includes ETFs like JO (Coffee), UNG (Natural Gas), and VXX (Volatility). Over time, if the underlying price doesn’t rise, these and other ETFs will see their value slowly decay. Usually the decay is dwarfed by price changes and might not always be obvious. VXX has a particularly high rate of decay with an average loss of 4% a month due to rollover, though that rate can vary significantly from month to month.

You can still make great returns from selective use of these instruments or finding and holding them during strong trends, but they should not be held arbitrarily for long periods of time.

Decay from Management Fees

ETFs aren’t free. There are a number of costs associated with them including the initial research and creation, marketing, on-going management, and various market maker and custodial costs.

The management fees on ETFs are quoted as an annual expense ratio. The industry average expense ratio is around 0.28% a year with the cheapest at 0.03% and some specialized funds charging well over 1.0%. These fees are deducted daily and evenly throughout the year through a process of adjusting the net asset value of the holdings of the ETFs.

You will likely never see or notice these fees in the normal course of holding an ETF, but they will show up in the form of decay relative to their underlying. The SPDR S&P 500 ETF, SPY, has an expense ratio of about 0.09% a year. That means that if you invested $10,000 in that ETF and held it and the S&P 500 was exactly flat for the year, the $10,000 investment would shrink by $9 in value from the management fee being withdrawn throughout the year.

ETF management fees are only a concern if they are particularly high or if you plan to hold the ETF for long periods of time. Most of the time, the management team is able to use economies of scale to reduce its costs and fees such so that they are quite reasonable for the services offered, particularly when compared with trying to replicate an ETF at a retail investor level.

When trading, it’s always important to understand the tools and instruments we are using. When we understand the pros and cons of each, we can choose the right tool for the job.