Leveraged ETFs: Are you prepared for the Volatility Jumps?

Linda Zhang

Journal of Index Investing, Summer 2018

A version of this paper can be found here

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What are the Research Questions?

The paper investigates the following research question:

What has the absolute risk behavior of leveraged products been historically? Did they behave as intended by design? Is the leverage multiple a reliable indicator of the volatility multiple? Is the leverage multiple a reliable indicator over shorter horizons?

What are the Academic Insights?

By studying the empirical evidence of the top 10 largest products from 2012 to 2016, the author finds the following:

YES- The top 10 largest levered products appear to deliver magnified gains and losses, as intended, over the entire sample period YES- The leverage multiple appears to be a reliable indicator of the volatility multiple. For instance, the largest ETF ProShares two-times-short S&P 500 had the volatility of 1.64% over the entire five-year period while its 1X product SPY’s volatility was of 0.83%. The ratio over the five-year period is roughly 2, just as the leverage multiple suggested NO-By analyzing the 3X ETF (UPRO), versus the 1X ETF (SPY), over the shorter 10-day period, the volatility ratio can deviate significantly from the indicated leverage multiple. The 3X product’s volatility can be as high as 3.3 times that of the 1X product. Among the many rolling windows, the volatility ratio has exceeded the leverage ratio many times. In fact, the author estimates that about 30% to 33% of the time, investors experienced higher volatility with leveraged ETFs than they were designed to have. Despite that, most high-volatility ratios fall within a reasonable two-standard-deviations range

Why does it matter?

This study provides an updated look at the leveraged and inverse global ETFs offerings. It alerts investors on the risk and return characteristics of these products, which are riskier than their one-time long-only counterparts. Specifically, their short-term risk characteristics can be even more volatile than the leverage multiple suggests.

Investors must grasp a full understanding of the complex risk behaviors of these instruments for effective use in their investment strategies. They need to be prepared for the jump in volatility in leveraged ETFs that may arise at the moment when they most need to avoid it.

The Most Important Chart from the Paper:

Abstract