Costs and Benefits of LETFs

Costs and Benefits of LETFs

Today’s post looks at a recent paper from Chris Murray and Marco Sammon of Harvard Business School. The paper was published in July 20206 and is called The Costs and Benefits of Leveraged ETFs (LETFs).

Approach and Findings

The paper looks at the costs, benefits, and investor behaviours associated with leveraged ETFs and the implications for retail investors.

The main conclusion of the paper is that leverage on indices can be useful, but that individual stocks are too volatile to benefit from leverage. 

I have no intention of investing in single-stock LETFs, so while this is an interesting result, I will focus on the index LETFs and only provide a brief summary of the work on single-stock LETFs.

There is another interesting finding, which is that LETF flows are different from those in unleveraged ETFs.

• LETFs are bought after falls and sold after gains (essentially a “buy the dip” strategy.
• Unfortunately, these flows are not predictive of future returns in the assets, which does not bode well for investors.

Again, this is contrary to my own use of LETFs, which is part buy and hold (particularly lower leverage funds, like 1.5x) and part momentum/trend driven (ie. buy after gains and sell after falls).

Leveraged ETFs

LETFs aim to deliver a fixed multiple of daily returns.

• The embedded financing, automatic rebalancing and real-time pricing and trading make for an attractive product 

But multi-day (and multi-month, multi-year) performance depends on return paths, volatility, management and financing fees, and trading behaviour (good or bad market timing).

• Volatility drag, driven by rebalancing, reduces long-term returns, especially for high-volatility assets (like single stocks)

In low-volatility environments, LETFs outperform their underlying assets, potentially generating large investor gains.

• As underlying volatility increases, LETFs tend to underperform due to higher volatility drag and costs, especially above 2% daily volatility

Index LETFs

Index LETFs typically track low-volatility assets with estimated funding spreads below 1%.

Broad equity-index LETFs have generated over $100 billion in investor gains, including $40 billion relative to holding underlying assets.

This rules out the standard story that volatility drag, fees, and financing costs always dominate the benefits of leverage. Applying leverage through an LETF can work when the underlying asset has high realized returns, low volatility, and low financing costs.

These products can create value for buy-and-hold investors when the underlying market has high returns, low volatility, and low financing costs.

Higher underlying volatility sharply increases the return needed for LETFs to outperform unlevered assets.

• Volatility drag increases with the square of the asset’s volatility and leverage, significantly affecting long-horizon returns.

At 5% daily volatility, a 2× LETF requires nearly 100% annual return to break even.

Single-Stock LETFs

In recent times, there have been market shifts from index to single-stock LETFs, with recent launches focusing on volatile, high-profile stocks.

Fund sponsors have incentives to create products that attract assets. And there is a large literature showing that investors are attracted to assets with lottery-like payoffs. 

Levered single-stock LETFs fit this demand especially well because they attach leverage to volatile individual stocks, increasing the perceived potential for large gains over relatively short horizons.

Single-stock LETFs are launched on highly volatile recent winners, attracting more assets but facing larger financing costs and volatility drag.

• LETFs are launched mainly on stocks with high recent returns and very high volatility, often above the 75th percentile.
• These stocks tend to be salient recent winners, attracting investor demand but also experiencing higher volatility drag.

Investor Trading Behaviour

LETF investors tend to buy after recent losses and sell after gains, showing contrarian trading patterns.

• Flows in LETFs do not predict future returns, indicating a lack of market timing skill from investors.

More volatile stocks attract significantly more assets, with a 1 percentage point increase in volatility leading to roughly 95-222% higher AUM.

• Demand concentrates in high-volatility products, which also have higher trading activity, especially in speculative categories like single stocks and crypto.

LETFs trade more actively than unlevered ETFs, with especially high turnover in single-stock, crypto, and VIX products.

• High trading activity suggests investors use LETFs mainly for short-term trading rather than long-term holding.

Conclusions

Here are the authors’ conclusions:

LETFs are not uniformly good or bad. The characteristics that make an asset attractive for product launch and investor demand, including volatility, salience, recent returns, and the possibility of large short-horizon gains, are also the characteristics that raise the breakeven return for LETFs. 

ETF sponsors earn fees on assets under management and benefit from products that attract assets and trading activity. Investors, meanwhile, appear to use LETFs as instruments for short-horizon reversal-seeking trades. Together, these forces can direct retail-accessible leverage toward products where the breakeven return is highest.

Unless you are an r/wallstreetbets degen, this paper is less interesting than it might at first appear.

• And if you are a degen, you are unlikely to heed its warnings, or indeed to read it at all.

The thrust of the paper is that single-stock LETFs are risky and difficult to make money from.

• I think we can all agree on that.

But the same cannot be said for index LETFs.

• And confirmation of this fact was the only reason that I read the paper.

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That’s it for today.

• Until next time.