Hartmut Graf, head of the index team at the German stock exchange in Frankfurt, gave a fascinating talk on the performance of leveraged indices at yesterday’s “Investing in ETFs” conference.

Graf started his presentation by recalling the basic fact about these indices – that they do not track the “equivalent” multiple of the underlying index return if held over long periods.  Why?  Because the simple effect of compounding and rebalancing on a daily basis leads to significant tracking error.

There are several good explanations on the internet of how this occurs, but one of the first and best was given by Tristan Yates and Lye Kok, here.

Essentially, what is called the “constant leverage trap” forces the fund to buy high and sell low, a strategy that goes against common sense.  The higher the volatility of the underlying market, the more likely that leveraged indices will lose ground, as well.  Furthermore, there’s absolutely no way of telling, given  a certain period return on the underlying index, what the leveraged, or leveraged index’s return will be.  What these derivative indices actually produce as a return is path-dependent; how you get to the end point is more important than what start and end levels of the “base” index actually are.

Graf reminded the audience that the expected ultimate value of an index that maintains constant leverage through daily or monthly rebalancing is zero.  And the higher the underlying market volatility, the sooner you eat up all your capital.

Essentially, holders of leveraged and leveraged index ETFs are the ultimate gamblers.  While these funds can deliver outsize returns for investors who get their market timing right, they are still playing a form of Russian roulette.

Full Story:  http://www.indexuniverse.com/blog/5831-where-next-for-leveraged-etfs.html

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