As volatility returns to the markets, it's worth revisiting leveraged ETFs and the tracking error associated with these products. The rules of the game are simple:
1. Leveraged ETFs do well relative to the underlying index in trending markets,
2. underperform in mean-reverting markets,
3. underperform significantly in mean-reverting high volatility markets,
4. underperform over longer periods of time,
5. inverse (bear) leveraged ETFs underperform more than the equivalent leverage bull ETFs. The tracking error for a bear ETF is equivalent to a bull ETF with an extra turn of leverage. That is an inverse ETF tracking error is equivalent to that of a 2x bull ETF. The error for a 2x inverse ETF is equivalent to that of a 3x bull ETF, etc.
The chart below shows a potential underperformance (in a mean-reverting market) for leveraged bull ETFs over a one-month period (roughly) as a function of daily volatility.
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The chart below shows the same for inverse ETFs (bear ETFs).
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Here is an example of what happens with leveraged ETFs over a longer period of time. The chart below compares TNA, a 3x Russel 2000 ETF with the performance of Russell 2000 (small cap index). The index is up some 12% YTD, while TNA instead of being up three times that is actually up less than half for the year.
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So if you really like risk, by all means take advantage of all the leverage available out there (before the SEC takes some "anti-derivatives" action against these products), but keep mindful of the nasty tracking error.
SoberLook.com