Levered Exchange-Traded Products: Theory and Practice
19 Pages Posted: 29 Nov 2017
Date Written: July 24, 2013
The introduction of levered exchange-traded products was heralded as a convenient mechanism for investors to enhance performance over traditional borrowing and leverage strategies. In many cases, these products have not generated the anticipated benefits. Because multi-period returns for levered and inverse products can depend on the path of the underlying asset’s returns, the rebalancing strategy is a crucial determinant of their success. The standard ETF approach is to rebalance on an end-of-day daily basis. Naive investors may base their expectations of these products on the expected performance of traditional “buy and hold” leverage. Optimal rebalancing decisions depend upon several interrelated factors, including the expected return pattern of the underlying asset and the investor’s time horizon. Empirical tests illustrate the pros and cons of two types of levered products under various scenarios. We find that in a majority of outcomes, term borrowing performs better than end-of-day daily rebalance leverage and increasingly so as volatility increases and holding periods expand. Daily rebalance leverage performs better in trending and in certain extreme market conditions.
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