A Levered ETF Anomaly Explained

TL;DR

This paper explains why leveraged ETFs underperform the S&P 500 during 2022-2023, attributing the discrepancy mainly to compounding, volatility, and covariance effects.

Contribution

It provides a detailed explanation of the levered ETF anomaly, highlighting the roles of compounding, volatility, and covariance in their underperformance.

Findings

Leveraged ETFs delivered negative returns despite the index rising.

Two-thirds of the underperformance is due to compounding and volatility.

Remaining difference is explained by covariance between ETF deviations and index returns.

Abstract

Counterintuitively, the S&P 500 Index rose between January 1, 2022, and December 29, 2023, while exchange-traded funds (ETFs) seeking to deliver 2x and 3x daily returns of the index delivered substantially negative returns. Roughly two-thirds of the difference between the returns of the index and the levered ETFs can be attributed to compounding and volatility. The remaining difference is explained by the covariance between the ETFs' deviations from constant leverage and the index's return.