Don't Understand Time Decay Issue Using Leveraged ETFs

[gonetowindsurf]

I am still trying to understand the time decay issue utilizing leveraged etfs in PP.

I have been monitoring a 2x portfolio using sso, ubt, dgp and shy and it has gained 42.27% vs the return of non-leveraged PP of 20.66% (42% vs 20% is pretty darn close tracking for more than 1 yrs worth of data imho) since beginning the strategy in 6/21/2010.

It seems that the leveraged asset that tanks is offset by the non-tanking, which is the concept of the traditional PP.

What am I missing?

[MediumTex]

I think it would be periods of low volatility that would cause the decay issue to be more pronounced.

[clacy]

I think the biggest problem would be the drawdowns that you could experience with leverage. 2x will result in at least twice the drawdown. Since most of us gravitate toward the hbpp because of the low volatility, we might not like the 40%+ DD that should be expected with the hbpp 2x.

[TripleB]

There's no financial instrument that can track 2x anything. In order to artificially create it in the ETF, they have to do some special "magic" and that only allows it to track 2x the position on a daily basis. Over long periods of time, there's no guarantee it will track 2x the position.

Here's the example of time decay:

"Index" starts out at $1000
2x ETF starts at $100/share.
Index goes up 1% to $101
The 2xETF goes up 2% to $102/share.
Index goes down 0.99% to $1000.
The 2xETF goes down 1.98% to $99.98.

Thus the 2xETF has lost 0.02% while the Index remained neutral, starting at $1000 and ending at $1000.

This is time decay and the leveraged ETF is guaranteed to lose money over time. The bigger the volatilty in the index, and the greater the leverage of the ETF, the greater the decay. Consider the following example:

"Index" starts out at $1000
3x ETF starts out at $100/share.
Index goes up 5% to $1050.
The 3xETF goes up 15% to $115.
Index goes down 4.67% to $1000.
The 3x ETF goes down 14.01% to $98.89.

In this example, the index also remained neutral, but the leveraged ETF has lost 1.11%.

Time decay is mathematically dependant on the leverage level of the instrument, and the volatility of the underlying instrument it is leveraged towards.

Additionally, as mentioned above, there's no guarantee the ETF will be able to perform 2x the underlying index for long periods of time, even in spite of time decay, because there's no way to do that. It's all financial engineering that is quasi-magical and subject to failure at any time due to counterparty risk.

[captain3d]

In its simplest form, a leveraged version of the PP could be acquired using an account that allows leverage - a margin account. The gains would be eroded because of the interest you would pay on the borrowed money. The leveraged etfs have similar problems to over come.

phil

[gonetowindsurf]

Thank you to all,
especially Triple B and Clive
for taking time to type out examples. You make perfect sense, now that I see on paper. And hopefully others can refer to your posts when they also don't get it.
Cheers,
Mike

[moda0306]

These leveraged ETF's seem not as appealing as using tax-deductible low-interest ARM (depending on whether you think rates will rise) mortgage debt, and making higher contributions to retirement accounts, appropriately mixing roth & traditional styles.... that is, if your situation allows this.

These are middle-class savings/tax vehicles that can be used creatively and safely, as opposed to creative wall-street concoctions without fail-safe mechinisms built in.