A study of leveraged ETF based on geometric return

Abstract

Leveraged (inverse) exchange-traded funds (LETFs) seek to deliver multiples (opposite) of the performance of the index or benchmark they track. LETFs typically are designed to achieve their stated performance objectives on a daily basis. Many real-life and hypothetical examples have been given to show that the performance of these ETFs over a period longer than one day can differ from their stated daily performance objectives. Formulae have been found using both continuous method and discrete method. A discrete method was used to find a formula linking the return of a leveraged fund with the corresponding multiple of the return of the unleveraged fund and its realized variance but the method needs to use some assumptions and statistical properties to create the volatility term. A CME report finds a very simple way to include volatility in their formula but fails to link to the return of the corresponding unleveraged product. In this paper, we find a natural way to link a leveraged fund with its corresponding unleveraged product and its realized variance in a discrete manner. Our derivation process is similar to that in the CME report, so we do not need to use assumptions and statistical properties to create the volatility term. Unlike the CME method, we use geometric return as opposed to arithmetic return. So, we are able to connect with the return of the corresponding unleveraged product.

Keywords:

• leverage
• ETF
• volatility
• geometric return
• arithmetic return
• Taylor’s theorem

AMS Subject Classifications:

• 62-07
• 62P-20
• 65D05

Notes

1 The first issuer of leveraged ETFs was Rydex in late 2006.[2]