Monday, January 13, 2014

Leveraged ETFs in 2013, where is your decay now?

Many people think that leveraged etfs in the long term underperform their benchmarks. This is true for choppy markets, but not in the case of trending conditions, either up or down. Leverage only has effect on the most likely outcome, not on the expected outcome. For more background please read this post.

2013 has been a very good year for stocks, which trended up for most of the year. Let's see what would happen if we shorted some of the leveraged etfs exactly a year ago and hedged them with their benchmark. 
Knowing the leveraged etf behavior  I would expect that leveraged etfs outperformed their benchmark, so the strategy that would try to profit from the decay would lose money.

I will be considering these pairs:

SPY 2 SSO -1 
SPY -2 SDS -1
QQQ 2 QLD -1
QQQ -2 QID -1
IYF -2 SKF -1

Each leveraged etf is held short (-1 $) and hedged with an 1x etf. Notice that to hedge an inverse etf a negative position is held in the 1x etf.

Here is one example: SPY vs SSO. 
Once we normalize the prices to 100$ at the beginning of the backtest period (250 days) it is apparent that  the 2x etf outperforms 1x etf.

 Now the results of  the backtest on the pairs above:
All the 2x etfs (including inverse) have outperformed their benchmark over the course of 2013. According to expectations, the strategy exploiting 'beta decay' would not be profitable.

I would think that playing leveraged etfs against their unleveraged counterpart does not provide any edge, unless you know the market conditions beforehand (trending or range-bound).  But if you do know the coming market regime, there are much easier ways to profit from it. Unfortunately, nobody has yet been really succesful at predicting the market regime at even the very short term.

Full source code of the calculations is available for the subscribers of the Trading With Python course. Notebook #307


  1. What about time decay? Isnt all of them based on Options and as such inherit their decaying property. Say if you look at QID vs S&P100 on 3/30/2007 S&P100=1772.36 and QID=53.71 but on 2/22/2008 where S&P100 almost same at 1773.44 we can see that QID=51.26. For me it clearly indicates time decay

  2. As you said it, the strategy cannot work in a trending market - not without rebalancing. (Very soon the leveraged etfs start "running away from you" and open up a directional market bet). Would your results be different if you rebalanced every week/month?

    1. Yes the results would be different. Frequent rebalancing would apply significant transaction costs, removing any alpha if there was any.

  3. I suspect it wouldn't be al that much, given that you rebalance only the "gap" - provided you use cheap brokers like IB. What's your email - I'll send you my workings (it's something I've been investigating for European indices)

    1. My email is on the right sidebar uner 'you can reach me at...'