jamaggie06 said:
And yes thats generally true. The S&P doesnt normally have large daily swings. But lets examine the effects of a market like today.
Generic unleveraged fund
Closes at $100 yesterday
Closes at $90 today. 10% drop
2 days later, back to $100
Using equally weighted gains for the two days
$90 x (1 + 0.054)^2 = $100
Generic 2X leveraged fund Y
Closes at $100 yesterday
Closes at $80 today. 20% drop
Using equally weighted 2x gains for the two days
$80 x (1 + 2 x 0.054)^2 = $98.25
Down 1.75% over the three day window the regular fund is even.
The decay is a function of the volatility. These funds get eaten up during volatile periods.
So, yes, it works great in stable markets, the decay is minimal. But exactly when you are hurting most, during periods of high volatility, it takes it in the shorts even harder.
Just something to keep in mind.
Note, it's even worse if it takes just one day for the unleveraged fund to return to $100. The leveraged fund would be at $97.78, or 2.22% decay in one day.
And the effect is worse (or rather, is more prominent on even smaller bouts of volatility) for 3x funds.
Sorry, two years later but I'm just reading through the decay comments.
It's true that volatility decay exists. It exists for levered and unlevered. It's just a mathematical fact of arithmetic averages. It's not unique to levered ETFs, though.
The following sequence +10%, -10%, +10% yields an average of 3.3%. If you actually experience that cycle you'd expect: 1 x (1+.033)^3 = $1.102.
Reality:
- $1 (1 + 10%) = $1.1
- $1.1 (1 - 10%) = $0.99
- $0.99 (1 + 10%) = $1.089
You lost a penny relative to the arithmetic mean expectation (again, at 1x leverage which we all have and experience some vol drag). It's why CAGR is so popular as it's a geometric mean.
Geo mean: ((1 + 10%) * (1 - 10%) * (1 + 10%))^(1/3) - 1 = 2.88% which is the real return.
Volatility drag does compound with leverage. So do the benchmark returns which everyone wants to ignore when discussing levered decay. So far my compounded levered returns on benchmark have outweighed the levered volatility drag (HFEA stress tested in March '20 and '08 & '20 for PSLDX).