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Understanding leveraged ETFs’ compounding effect

Narat Charupat (DeGroote School of Business, McMaster University, Hamilton, Canada)
Zhe Ma ( School of Intelligent Finance and Accounting Management, Guangdong University of Finance and Economics, Guangzhou, China)
Peter Miu (DeGroote School of Business, McMaster University, Hamilton, Canada)

Managerial Finance

ISSN: 0307-4358

Article publication date: 1 September 2022

Issue publication date: 2 January 2023

49

Abstract

Purpose

Prior literature has shown that, theoretically, holding-period returns of a leveraged exchange-traded fund (LETF) are generally negatively affected by the volatility of the underlying benchmark’s daily returns, particularly for long holding periods. However, recent empirical studies simulate LETFs’ returns using historical benchmark returns and report results that are not entirely consistent with the theoretical predictions, leading to the possibility that the distribution of real-world returns may have certain characteristics that influence the outcomes. In this paper, the authors examine how asymmetric volatility affects LETFs’ performance and provide detailed explanations for the behavior of the performance of LETFs under different market conditions.

Design/methodology/approach

The authors conduct simulation analyses on a +3x LETF and a −3x LETF based on historical S&P 500 stock index returns, with asymmetric volatility incorporated into the model.

Findings

By incorporating the asymmetric volatility effect, the simulation results suggest that, contrary to the theoretical predictions, higher volatility does not always lead to more negative impact on LETFs’ performance. Rather, the performance depends on the market conditions under which high volatility occurs. The findings therefore help reconcile prior theoretical predictions with reported empirical findings.

Originality/value

The analysis adds to the literature by incorporating the asymmetric volatility effect of stock returns in studying LETFs’ performance. The authors also provide detailed explanations for the behavior of LETFs’ returns and compounding effect under different market conditions, thus providing contexts to prior empirical results.

Keywords

Acknowledgements

Charupat and Miu gratefully acknowledge the financial support from the Social Sciences and Humanities Research Council of Canada.

Citation

Charupat, N., Ma, Z. and Miu, P. (2023), "Understanding leveraged ETFs’ compounding effect", Managerial Finance, Vol. 49 No. 1, pp. 163-186. https://doi.org/10.1108/MF-07-2022-0307

Publisher

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Emerald Publishing Limited

Copyright © 2022, Emerald Publishing Limited

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