Leveraged ETFs: Admissible Leverage and Risk Horizon

Abstract

This paper provides a quantitative risk analysis of leveraged ETFs (LETFs) with a focus on the impact of leverage and investment horizon. From the empirical returns of several major LETFs based on the S&P 500 index, the performance of LETFs generally declines as investment horizon increases, compared to the reference index. The value erosion is more severe for highly leveraged ETFs. To better understand the risk impact of leverage, we introduce the admissible leverage ratio induced by a risk measure, for example, value-at-risk (VaR) and conditional VaR. This idea can help investors exclude LETFs that are deemed too risky. Moreover, we also discuss the concept of admissible risk horizon so that the investor can control risk exposure by selecting an appropriate holding period. In addition, we also compute the intra-horizon risk, which leads us to evaluate a stop-loss/take-profit strategy for LETFs. Lastly, we investigate the impact of volatility exposure on the return of different LETF portfolios.

Keywords: leveraged exchange-traded funds, value-at-risk, risk measure, risk horizon

JEL Classification: G12, G13, G17