Leveraged exchange-traded funds: admissible leverage and risk horizon

Tim Leung and Marco Santoli

Abstract

ABSTRACT

This paper provides a quantitative risk analysis of leveraged exchange-traded funds (LETFs) with a focus on the impact of leverage and investment horizon. From the empirical returns of several major LETFs based on the S&P 500 index, the performance of LETFs generally declines as the investment horizon increases, compared with the unleveraged ETF on the same index. The value erosion is more severe for highly leveraged ETFs. To better understand the risk impact of leverage, we introduce the admissible leverage ratio induced by a risk measure, for example, value-at-risk (VaR) and conditional VaR. This idea can help investors exclude LETFs that are deemed too risky. Moreover, we also discuss the concept of admissible risk horizon so that the investor can control risk exposure by selecting an appropriate holding period. In addition, we also compute the intrahorizon risk, which leads us to evaluate a stop-loss/take-profit strategy for LETFs. Lastly, we investigate the impact of volatility exposure on the return of different LETF portfolios.