doubling down with levered ETFs
This weekend I read Jason Zweig’s “Will leveraged ETFs Put Cracks in Market Close?” which references a paper by Minder Cheng and Ananth Madhaven at Barclay’s. I tried, but couldn’t find their original paper over the weekend. As luck would have it from across the internets Paul Kedrosky came to the rescue with a post referencing that paper, “The Dynamics of Leveraged and Inverse Exchange-Traded Funds“.
If you have any interest in ETFs, then you should read this paper carefully as it provides a very nice and accessible mathematical treatment of leveraged and inverse ETFs.
I’ve had success using ETFs in portfolio-oriented strategies to conveniently provide specific exposures, eg, to emerging markets. I’ve also explored strategies that pit ETFs against futures and similar arbs that take advantage of contract rolls or other anomalous behaviors across the markets. But I’ve never looked at ETFs the way they really should be understood: as structured products that should have well-defined (if not necessarily obvious) properties.
Like many structured products, some of these characteristics are not obvious and may be quite unintuitive but are always important to understand. For instance, the hedging required to implement these funds is both non-linear and asymmetric.
Specifically, leveraged ETFs must re-balance their exposures on a daily basis to produce the promised leveraged returns. What may seem counterintuitive is that irrespective of whether the ETFs are leveraged, inverse or leveraged inverse, their re-balancing activity is always in the same direction as the underlying index’s daily performance. The hedging flows from equivalent long and short leveraged ETFs thus do not “offset” each other. [...]
The impact is particularly significant for inverse ETFs. For example, a double-inverse ETF promising -2X the index return requires a hedge equal to 6X the day’s change in the fund’s Net Asset Value (NAV), whereas a double-leveraged ETF requires only 2X the day’s change. This daily re-leveraging has profound microstructure e ffects, exacerbating the volatility of the underlying index and the securities comprising the index.
Hence Mr Zweig’s concern that these ETFs feed the volatility we’ve seen for the last 8 months or so near the market close. If the day has been up then both “bull” and “bear” levered ETFs will need to buy in order to stay hedged - reinforcing the trend and effectively supporting serial correlation of returns.
While the war over the latest+greatest video cards for the current generation of graphics intensive games seems always to ebb and flow between nVidia and its arch-rival ATI, I’ve long preferred nVidia for their better support of Linux. Thus, all of my machines have some sort of nVidia Graphics Processing Unit (GPU) in them.
A friend recently asked me what I considered to be the “axioms” of alpha-seeking trading strategies. I think there are a few, but probably the one that seems to me most important is that the atomic element of a trading strategy should always be a portfolio as opposed to a single instrument.
The always excellent 
I’m very pleased to present our first guest blogger to this space - Scott Johnston. Scott’s an experienced hedge fund exec who’s currently a PM and principal at the 
He didn’t look like much, but old Rocky Marciano put his back into every awkward punch he threw. More remarkably, he remains the only heavyweight champion to have ever been smart enough to get out of the game on top. He was that rarest of characters - a winner who knew when to engage and when to step away.
