Leveraged Exchange-Traded Funds Versus Investing on Margin

Abstract

Motivated by the SEC’s recent discussion on leveraged exchange-traded funds (LETFs) and LETFs’ rapid growth, this study provides an analytical and empirical comparison of the performance of LETFs versus traditional investing on margin. First, we prove that the return distribution of LETFs has higher skewness than that of a market portfolio on margin, which may reduce downside risks for investors. Second, we empirically test the daily-return model used in literature to construct LETF returns, and find that the published expense ratio may underestimate the actual cost of those funds for investors. Third, using historical data, we replicate the returns of LETFs and market portfolios on margin. The empirical results show that across different holding periods, the returns of the LETF strategies are higher (lower) than that of market portfolios on margin during strong (moderate) bull and strong (moderate) bear markets. LETFs also provide lower downside risks, and a simple strategy based on the 3× LETF can generate higher risk-adjusted return. Moreover, we find that the LETFs are less risky during every bear market since 1927.