Returns of Matched Long and Short Leveraged ETFs

Is “Shorting Leveraged ETF Pairs” a good idea? In their brief March 2012 paper entitled “Levered ETFs”, Wenxi Jiang and Hongjun Yan examine the returns from matched positions in long and short leveraged exchange-traded funds (ETF). Specifically, they calculate returns from shorting matched pairs. Using data for matched 2X/-2X and 3X/-3X ETFs during 2007 through 2011, they find that:

• Over the entire sample period, shorting matched long and short leveraged ETFs generates annual gross returns in the range 4% to 7%, depending on the amount of leverage and the volatility of the underlying asset.
• There are three sources for this grind against fund values:

1. The fund bears transaction costs in making adjustments to maintain targeted leverage. Shorting long-short leveraged ETF pairs is therefore more profitable when the underlying asset is volatile or less liquid and, all else being equal, for 3X leveraged pairs compared to 2X.
2. Shorting long-short leveraged ETF pairs is more profitable when arbitrage is especially costly (when expected market volatility, as measured by VIX, is high).
3. There is a lag between changes in the price of the underlying asset and adjustments to prices of associated leveraged ETFs. In combination with the daily rebalancing of positions in the long-short ETF pair, this lag tends to generate a gross positive return. The greater the price adjustment lag, the greater the gross positive return.

In summary, evidence suggests that shorting matched pairs of long and short leveraged ETFs tends to be profitable at a gross level.

Cautions regarding findings include:

• Reported results are apparently gross and assume daily rebalancing of the long-short pairs to equal weight. Including the costs of daily rebalancing would materially reduce returns. For example, daily rebalancing with an average trading friction of 0.1% compounds to an annual friction of about 22%.
• Returns apparently ignore costs of shorting, and any restrictions on shorting of specific leveraged ETFs. When shorting is possible, including the cost of borrowing shares would reduce reported returns.
• The paper does not identify the leveraged ETF pairs considered. Results may vary for specific pairs (see “Multi-year Performance of Leveraged ETFs” and “Multi-year Performance of Non-equity Leveraged ETFs”).