Leveraged Investment Products: Monthly Rebalancing Boosts Performance, but Tail Risk Looms

Volatility reduces any investment’s compound rate of return in what is termed volatility drag, a drawback of leveraged investment products (LIPs). In recent years “Version 2.0” LIPs that reset leverage monthly (monthly LIPs) have been created to lessen the impact of drag. We show that monthly LIPs improve returns because markets are less volatile on a monthly timescale. Nevertheless, monthly LIPs remain problematic as buy-and-hold investments because of the risks of large drawdowns and catastrophic losses. We characterize these risks through higher-order moments and identify attributes of LIPs to mitigate these risks to benefit both LIP investors and LIP sponsors. TOPICS: Exchange-traded funds and applications, volatility measures, performance measurement Key Findings • Leveraged investment products (LIPs) that rebalance leverage monthly provide higher returns than the standard LIPs that rebalance daily. Monthly leverage rebalancing reduces volatility drag because markets exhibit lower realized volatility on a monthly timescale. • Monthly LIPs remain problematic as buy-and-hold investments because of the risks of large drawdowns, excess leverage, and catastrophic losses—risks that are captured not by standard mean-variance and simulation analyses but by our model through higher-order moments. • Buy-and-hold investors should focus on monthly LIPs with broad diversification, low volatility, and intramonth leverage rebalancing that avoids outright liquidation in times of market stress. LIP sponsors should emphasize these same qualities in designing their investment products.