Leveraged Exchange Traded Funds Revisited: Enhancing Returns or Adding Risk?

Leveraged Exchange-Traded Funds (LETFs) are financial instruments designed to amplify the daily returns of an underlying index or asset, often using derivatives and debt. Typically, LETFs aim to achieve a multiple (e.g., 2x or 3x) of the daily performance of the tracked benchmark, both on the upside and downside. LETFs are commonly used for speculative purposes, hedging, or tactical portfolio adjustments, but they require careful management and a solid understanding of the risks involved.

LETFs have received a lot of criticism. Despite the controversy, they remain popular among institutional investors. Reference [1] revisits the use of LETFs in portfolio allocation. The authors pointed out,

Using both closed-form and numerical solutions, we showed that an investor can exploit the observation that LETFs offer call-like payoffs, and therefore could be a convenient way to add inexpensive leverage to the portfolio while providing extreme downside protection.

Under stylized assumptions including continuous rebalancing and no investment constraints, we derived the closed-form IR-optimal investment strategy for the LETF investor, which provided valuable intuition as to the contrarian nature of the strategy. In more practical settings of quarterly trading, leverage restrictions, no trading in the event of insolvency and the presence of margin costs on borrowing, we employed a neural network-based approach to determine the IR-optimal strategies. Our findings show that unleveraged IR-optimal strategies with a broad stock market LETF not only outperform the benchmark more often than possibly leveraged IR-optimal strategies derived using a VETF, but can achieve partial stochastic dominance over the benchmark and (leveraged or unleveraged) VETF-based strategies in terms of terminal wealth.

In short, by using LETFs with active allocation, investors can outperform both buy-and-hold strategies and those that use non-leveraged ETFs.

An interesting finding of this study is that, through a closed-form solution and numerical simulations, the authors demonstrated that LETFs behave like call options. Based on this, it is intuitive that if LETFs are part of a portfolio, they can enhance risk-adjusted returns.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Pieter van Staden, Peter Forsyth, Yuying Li, Smart leverage? Rethinking the role of Leveraged Exchange Traded Funds in constructing portfolios to beat a benchmark, 2024, https://ift.tt/Mbv7UQY

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