Understanding the Tracking Errors of Commodity Leveraged ETFs

TL;DR

This paper investigates the tracking errors of commodity leveraged ETFs, introduces a benchmark accounting for volatility decay, and evaluates trading strategies to understand their performance and discrepancies from targets.

Contribution

It constructs a new benchmark incorporating volatility decay and quantifies ETF underperformance using the realized effective fee.

Findings

Many ETFs underperform significantly against the benchmark.

The realized effective fee provides a novel measure of tracking discrepancy.

Backtested trading strategies reveal varying performance levels.

Abstract

Commodity exchange-traded funds (ETFs) are a significant part of the rapidly growing ETF market. They have become popular in recent years as they provide investors access to a great variety of commodities, ranging from precious metals to building materials, and from oil and gas to agricultural products. In this article, we analyze the tracking performance of commodity leveraged ETFs and discuss the associated trading strategies. It is known that leveraged ETF returns typically deviate from their tracking target over longer holding horizons due to the so-called volatility decay. This motivates us to construct a benchmark process that accounts for the volatility decay, and use it to examine the tracking performance of commodity leveraged ETFs. From empirical data, we find that many commodity leveraged ETFs underperform significantly against the benchmark, and we quantify such a discrepancy via the novel idea of \emph{realized effective fee}. Finally, we consider a number of trading strategies and examine their performance by backtesting with historical price data.