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Understanding Levered ETFs and Geometric Returns

Jan 04, 2009 - 4:53 AM EST

ETF Wanderer submits:

A lot of authors on Seeking Alpha have noted that levered ETFs don’t behave as some investors intended to due to compounding effects. The levered or inverse products do what they say over a period of a single day, but not over a longer time-period. Recent examples are the post by Paul Kedrosky, where both levered bullish and bearish energy ETFs were negative simultaneously and another post by Matthew McCall, where he noted both a financials ETF and a 2x inverse financial ETF lost over the same period.

To understand better, assume the ETF asset follows a Geometric Brownian Motion (the same assumption used to derive Black-Scholes formula for options). The assumption is not perfect, but not far from reality.

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Source: Seeking Alpha (Jan 04, 2009 - 4:53 AM EST)