One of the main reasons that many quantitative traders are attracted to the futures markets is the amount of leverage that those products offer. Traders seeking ways to leverage their systems can also make use of leveraged ETFs, but how well do those ETFs actually produce leveraged results?

If an ETF is supposed to replicate two or three times the returns of a particular market or index, any variation could severely impact a trading system. If the ETF doesnt achieve its target leverage, your system will underperform. If it is overleveraged, the system will be exposed to a greater risk of ruin.

Using leveraged ETFs can be very appealing, but how well do those ETFs actually track the markets they represent?

CXO Advisory group published an article that breaks down the daily and long term variations between leveraged ETFs and their targets. They profiled 46 different 2X and -2X ETFs and 10 3X and -3X ETFs in order to determine exactly how accurate these leveraged ETFs actually are in real trading.

Here is how they got started:

We measure achieved average daily leverage by comparing the average daily return of each leveraged ETF to the average daily return of a 1X ETF designed to track the same index.

We measure achieved long-term leverage by comparing the terminal return of each leveraged ETF to the terminal return of a 1X ETF designed to track the same index.

These are the results they discovered for the 2X and -2X ETFs:

The 2X (-2X) ETFs modestly underachieve (achieve or slightly overchieve) targeted daily leverage on average, perhaps due to leveraged fund expenses and the contribution of dividends to the underlying 1X ETFs.

The 2X ETFs generally do not deliver the targeted daily leverage over a long period. Terminal leverages range from -1.8 to 35.1, with the latter outlier (real estate sector) relating to a 1X underlying ETF with a small negative terminal return.

The -2X ETFs are generally more consistent than the 2X ETFs over a long period, with all these funds losing most of their value. However, two of the -2X funds deliver positive leverage. The outlier with leverage 3.0 relates to an underlying 1X ETF with negative terminal return (financial sector). The outlier with leverage 46.6 relates to the same underlying ETF as the above 2X outlier (real estate sector).

Here are the results they discovered for the 3X and -3X ETFs:

As above, the 3X (-3X) ETFs slightly underachieve (overchieve) targeted daily leverage on average, perhaps due to leveraged fund expenses and the contribution of dividends to the underlying 1X ETFs.

Over the generally bullish sample period, the 3X ETFs are generally effective at delivering terminal leverage.

However, the -3X funds do not (cannot) deliver -3X leverage, which would require negative fund values. This result reflects the asymmetry of gains and losses based on simple returns (the largest possible loss is -100%).