Where Does Leveraged ETF Leakage Go?

Apologies to the physics, transhumanism, nanotech, and AI enthusiasts out there, but every once in a while I get the urge to blog about something completely unrelated to the main themes of this site.  Usually, it is to get something off my chest, or to make a prediction (e.g. see “Do the Math – Hillary Can’t Win“).  This time it is about another one of my passions – trading.

I read something posted by a reputable brokerage house the other day; an article warning investors of the dangers of trading leveraged ETFs.  I did a little research and found that all brokerage houses are sending similar warnings to their customers, likely due to clueless investors who lose their shirts trading things they don’t understand and then whining to the SEC to make it stop.

ETFs are Exchange Traded Funds, similar to Mutual Funds in that they represent a collection of stocks, bonds, or other financial instruments, but different in that the can be traded on exchanges just like stocks.  There are all kinds of ETFs, ones that follow market indexes, ones that track currencies, commodities, bond markets, ones that follow different geographical regions, ones that go up when the market goes down (Bear ETFs), and so on.  Like Mutual Funds, there are also leveraged ETFs, or ETFs that move more than the underlying index moves.  For example, an ETF may be a S&P 2X fund, which means when the S&P Index moves 1% in one direction, the ETF will typically move 2%, or twice as much.  These are the risky ones, according to the SEC and brokers.  Why?  Because of something that I’m going to call “leakage.” I haven’t seen that word used yet, but it seems fitting and descriptive.

According to the analysis, lets say an underlying index goes from 100 to 105, or up 5%.  A 2X leveraged ETF based on that same index would therefore go up 10%.  So, if it was trading at 100, it would go up to 110.  Now, let’s say that the index drops back to where it started from, from 105 to 100, for a drop of 4.762%.  According to the leverage model, the ETF should drop twice that amount or 9.524% from 110 down to 99.52.  So it seems that because of the up and down price action of the market, the leveraged ETF has actually “leaked” .48%.  Imagine a market that continuously fluctuates – then the ETF would slowly leak away its value.  Sounds scary, doesn’t it, especially for those who realize how much the market fluctuates day to day.
So, out go all the warning notices.

But something doesn’t seem right to me.

First of all, for every buyer, there is a seller.  For every position in the market, there is an opposite position.  So, if a long position on a leveraged ETF slowly leaks away its value, where does that money go?  (And no, it doesn’t automatically transfer into the accounts of the cigar smoking Illuminati.)  Does that mean that shorting leveraged ETFs will slowly make money, like a money  tree?  Or like grey goo slowly gobbling up the earth (I threw that in so that nanotechies find this article when it gets indexed in Google).  No, doesn’t make sense.

When you think about it, any financial instrument that is leveraged, such as a stock with a “Beta” greater than 1, would succumb to this process.  In fact, leveraged ETFs are often composed of stocks with Beta > 1.  If I remember right from linear algebra, a process can be broken down into a superposition of processes.  In other words, if an ETF leaks, so must the high-Beta stocks on which it is based.  But again, this makes no sense at all.  If I own 100 shares of stocks and it fluctuates wildly, the only two ways I could get leakage is if my number of shares leak (which of course they don’t – you buy 100, you always have 100), or the value of the company leaks (which of course it doesn’t).

So, I’m sorry financial wizards, but while it is nice to warn the masses about the dangers of leveraged trading, your arguments don’t hold water on the ETF issue.  If anyone can explain to me where the leakage goes, I’ll gladly post the rebuttal and/or remove my post.

~ by thearchitect on September 17, 2009.

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