Levered and Inverse Exchange-Traded Products: Evidence from Simulations

Abstract

Levered exchange-traded products have been criticized as offering inferior long-term returns for two reasons: their higher volatility and, apparently, the belief that volatility diminishes long-term expected returns. Following the approach of Pessina and Whaley (2021) we analyze simulated returns of levered and inverse exchange traded funds (ETFs) and conclude that their expected long-run values are not diminished by volatility. We identity natural counterparties to the rebalancing trades of levered exchange traded funds (LETFs) and analyze the impact of autocorrelation on daily-rebalanced LETF returns, theoretically and empirically, for both LETFs and their counterparties. The results indicate that negative (positive) autocorrelation in daily returns will cause LETFs to perform relatively poorly (well) and their counterparties to perform relatively well (poorly). Accordingly, the extent to which levered and inverse ETFs have legitimate hedging applications and reasonable risk-adjusted returns (setting aside trading costs and fund expenses) depends on the extent to which the underlying returns are consistent with weak-form market efficiency.