In current market conditions it is actually a benefit rather than a drawback for sp500 leveraged ETFs

Guest post by joeyaa

for example. The other big cost, which historically is extremely high, is the implied interest rate it takes to leverage. I’ll talk about slippage cost first though.

The slippage cost is magnified or actually inverted depending on what the market volatility is. The prospectus for these funds have a chart showing the impact on what this slippage cost will actually be depending on what the underlying index volatility is. In the conditions like 2017 with extremely low volatility, the fund makes money, not loses it, from this factor overall. In a sideways year the fund will still lose money. However, in a down trending or up trending year the fund will lose less than expected or win more than expected. Look at this chart to confirm:

ibb.co/fft18b

You will see that as you go right on this chart that, as index volatility increases, the slippage cost increases / benefit shrinks.

I broke down what the annual sp500 returns were by year over the last 50 to get an idea of what the expected return will be on a given random year. If you average it out then on here is what happens from slippage:

10% Volatility: UPRO makes 8% more than expected

15% Volatility: UPRO makes 3% more than expected

20% Volatility: UPRO makes 4% less than expected

25% Volatility: UPRO makes 12.5% less than expected.

Why does this happen? In markets that gain and then lose .3% in a day, slippage costs almost nothing when the market breaks even. It is more likely to actually gain from slippage on +.3%, +.3% when gains over a year are incrementally so small. Compounding works in your favor more than getting whipsawed hurts you. Whereas if the market is losing and gaining 10% in a day, you will quickly go broke because even if the underlying index is expected to make 10% in a year, that will translate into too many whipsaw days, which will be the majority.

The numbers stated here can be given some margin for error, in either direction, but not that much. This is reasonably accurate and stays similar over different time frames.

That is one big component of the cost of this fund. It isn’t the biggest cost most of the time. The fund fee itself is 1%. However, there is also an implied interest rate that you’re paying to hold the fund. What exactly is this implied interest rate? For 3x leveraged funds it is (Libor + ~.2%) * 2.7. In the past few years that expense was very low – almost free in fact. As libor creeps up to 3+, it starts to become a very significant expense.

Thoughts are: Do not hold leveraged ETFs for long periods of time when interest rates are high or the underlying index volatility is high. These are both highly predictable things. Do not hold leveraged ETFs when the market very often goes sideways, as they do for some assets.

Other thought is that for other funds the volatility cost is out of this world. Index volatility for the nasdaq is about 5% higher than sp500 which will begin to cost very serious money during high volatility periods. You can see that the cost does not scale linearly from the chart – if your index volatility is 30%+ it is impossible to see how this would be a profitable buy/hold. Even at 25% it is likely not worth the risk, even when libor is low. Underlying index volatility for something like YINN means you are in fact incinerating money for the reasons that are getting talked about in this thread.

 

Disclaimer: Consult your financial professional before making any investment decision. This is a guest post and it doesn’t represent the views of IWB.

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