Short-Selling Leveraged Exchange-Traded Funds

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Leveraged exchange-traded funds (ETFs) are investment vehicles that aim to provide amplified returns for a given index or benchmark. Leveraged ETFs use financial derivatives and debt to enhance their returns, which can be either two or three times the return of the underlying index, on a daily basis. This means that if the underlying index returns 1% in a day, a 3x leveraged ETF tracking that index will return 3%.

Leveraged ETFs are designed for short-term trading, as the effects of compounding can cause their returns to deviate from the underlying index over longer holding periods.  Leveraged ETFs are characterized by two prominent features: volatility decay and path dependency. Volatility decay refers to the tendency of the leveraged ETF to lose value over time as a result of the daily resetting of leverage. This occurs because leveraged ETFs use derivatives and other financial instruments to amplify the returns of a particular index, but the daily rebalancing of the leverage can lead to compounding losses when the underlying index experiences volatility.

Path dependency refers to the fact that the returns of a leveraged ETF depend on the path of the underlying index over time. This means that even if the underlying index experiences an overall gain over a given period, the returns of the leveraged ETF may be negative due to the effects of volatility decay and the timing of the leverage rebalancing. Similarly, a leveraged ETF may experience large losses even if the underlying index experiences a modest decline, again due to the effects of volatility decay and the timing of the leverage rebalancing.

Given these characteristics of leveraged ETFs, reference [1] examined investment strategies that consist of shorting leveraged ETFs. The authors pointed out,

This study examines the profitability of short-selling strategies of different portfolios with varying combinations of bull and bear Leveraged Exchange-Traded Funds (LETFs). We find that while short-selling the combination of both bull and bear LETFs does not yield significant positive returns compared to the market, short-selling a portfolio with only bear LETFs can significantly outperform the market, especially if the position is established after a period of heightened market volatility. Moreover, using machine learning techniques, we show that as the correlation of LETFs with their underlying index increases, the return from short-selling both bull and bear LETFs decreases. At the same time, an increase in the net asset value (NAV) of bull LETFs results in an increase

In brief, short-selling a combination of both bull and bear leveraged ETFs did not yield significant positive returns. This means that the market is efficient in this regard.

We found the second finding interesting, i.e. short-selling a portfolio with only bear leveraged ETFs can significantly outperform the market, especially if the position is established after a period of heightened market volatility. However, we don’t think that the authors have taken the borrowing fees into account. If the borrowing fees are taken into account, the excess returns can diminish.

Let us know what you think in the comments below or in the discussion forum.

References

[1]  Khadivar, Hamed and Nikbakht, Elaheh and Walker, Thomas, Investigating Long-Term Short Pairing Strategies for Leveraged Exchange-Traded Funds Using Machine Learning Techniques (2023). Journal of Investing, https://ssrn.com/abstract=4405467

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