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Decay Can Affect Cyclists Too

July 29th, 2009 Kevin

There are plenty of articles on the topic of how decay affects leveraged and inverse ETFs. Just recently there has been news of brokers putting them under review or even not allowing their clients to use them. Critics of leveraged ETFs often claim that they are flawed and they like to point out the decay that has occurred in FAS and FAZ since their inception. They claim leveraged ETFs are a one way ticket to zero (or reverse splits) and they love to mention how the funds have to buy high and sell low to achieve their goals.

I agree that leveraged ETFs may be highly misunderstood and extremely dangerous, but they actually achieve their stated goals (daily leveraged percent change tracking) probably better than most people think. It does not matter that the ETF internals need to buy high and sell low. What matters is that they should work as advertised, and that traders or investors should understand how they work over their respective timeframe before they decide to use them.

Meet Marcus and Larry

In order to illustrate how leveraged ETFs decay for a reason and why it is not a ‘flaw,’ I will demonstrate an alternate scenario outside of the world of finance that also experiences decay. To keep things as simple as possible it will be explained using a 5th grader’ish storyline.

Imagine three bicyclists that are training for a long race. Their names are Igor Index, Marcus Margin, and Larry Leverage. Igor is a veteran and has lots of experience. His training regimen is very strict. He alternates days where he rides a long distance and then a shorter distance.  More specifically, on Monday he rides 100 kilometers, Tuesday he rides 80 km, Wednesday back to 100 km, and so on. Though his short rides are only 20 km less, Igor has found this training schedule has helped him become one of the best cyclists in the world.

Two up and coming young cyclists named Marcus Margin and Larry Leverage idolize Igor and they have been looking for a training schedule that will put them in better shape for competitions. Marcus has studied Igor’s training technique and decided he will do twice the change value of Igor. Rather than do 20 km less on Tuesday and Thursday, Marcus decides to double it and do 40 km less. Larry Leverage has decided to do things a bit differently. Larry wants to double the percent change that Igor does each day. Using this training plan, we can see what each cyclist will do on Tuesday.

It is clear that both Marcus and Larry will be riding less on Tuesday, both by the same amount. However when Wednesday comes around, Igor increases his riding by 20km (25% of the 80 km), Marcus doubles Igor’s 20 km increase for a 40 km increase, and Larry decides to do double Igor’s percent increase for a 50% increase. Since Larry rode 60 km on Tuesday, an extra 50% puts him at 90 km. What he does not realize is that just tracking Igor’s percent change will cause his training to have some weird effects if he continues over multiple days. A chart shows what happens to the Wednesday bike ride.

Over the course of two days Larry’s long ride has become 90 km instead of 100 km all because he decided to track Igor’s changes by percent instead of value. If Larry keeps this up, after one month he will have a long ride of 35 km instead of Igor’s 100 km long ride. This is proof that decay in leverage ETFs does not happen due to buying high and selling low, it is from them working as they should: daily leveraged percent change tracking.

Decay is not a ‘flaw’

Even if the leveraged ETF fund managers had nightly parties where they take turn shoveling money into a furnace, as long as the funds meet their stated goals, it seems irrelevant as to how they achieve them.

To those that think leveraged ETFs are flawed:

  • Decay is by design.
  • Trends can offset the decay.
  • Decay of leveraged ETFs tracking the S&P 500 is roughly 20 times less during normal volatility.
  • Decay of leveraged ETFs tracking the financials is roughly 40 times less during normal volatility.
  • Any instrument that has goals similar to leveraged ETFs is also affected by decay.

The only flaw is when someone expects these instruments to perform 2x or 3x over long time periods. Just like it would be flawed to think a car with a V12 engine is going to use the same amount of gas as a V4 engine. In all fairness, a V12 versus V4 engine gas usage comparison is probably more obvious than understanding why leveraged ETFs are affected by decay over long timeframes. Hence, I can understand people’s frustrations and confusion. That is why this blog attempts to spread information about how leveraged ETFs work; so that traders or investors can be better informed for the decisions they make.

We avoided a disaster

I am not opposed to people that think leveraged ETFs should not be used. That is their opinion and they are entitled to it. It is actually good that leveraged ETFs have become more popular during the past year instead of before the 2008 crash. The abnormally high volatility has amplified the effects of decay and significantly increased awareness of how these ETFs work. Had leveraged ETFs become popular 5 years ago during the bull market, investors probably would have piled into them long term, not prepared for the financial tsunami that was about to hit. Long term investors probably would have been blind-sided by the compounding effects of the market going down coupled with the negative effects of decay during the once in a lifetime volatility. Now that market volatility has subsided, the leveraged ETFs are becoming much less affected by decay. Future articles will go more in depth on just how well leveraged ETFs track, and the kind of decay we should expect to see in the future at normal levels of volatility.

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