Solving the Leveraged ETF Compounding Problem

Abstract

It is well established that holding leveraged exchange-traded funds (ETFs) over an extended period of time generally results in returns substantially less than the daily multiple might imply. This is due to the compounding problem caused by the volatility of returns. However, in periods of low volatility, the compounding issue can actually work for investors. The trick is avoiding leveraged funds during periods of high volatility. Using the CBOE Volatility Index (VIX) as a forecasting tool for expected future volatility, this study shows that in the past 20 years, judiciously investing in bullish leveraged ETFs over longer time frames can actually lead to magnified returns greater than the daily leverage implies and increases, the return–risk trade-off as measured by standard Sharpe ratios.