## Summary

- Leveraged ETFs suffer from decay, or “beta slippage.” Researchers have attempted to exploit this effect by shorting pairs of long and inverse leveraged ETFs.
- The results of these strategies look good if you assume continuous compounding, but are often poor when less frequent compounding is assumed.
- In reality, the trading losses incurred in rebalancing the portfolio, which requires you to sell low and buy high, overwhelm any benefit from decay, making the strategies unprofitable in practice.
- A short levered ETF strategy has similar characteristics to a short straddle option position, with positive Theta and negative Gamma, and will experience periodic, large drawdowns.
- It is possible to develop leveraged ETF strategies producing high returns and Sharpe ratios with relative value techniques commonly used in option trading strategies.

## Decay in Leveraged ETFs

Leveraged ETFs continue to be much discussed on Seeking Alpha.

One aspect in particular that has caught analysts’ attention is the decay, or “beta slippage” that leveraged ETFs tend to suffer from.

Seeking Alpha contributor Fred Picard in a 2013 article (“What You Need To Know About The Decay Of Leveraged ETFs“) described the effect using the following hypothetical example:

To understand what is beta-slippage, imagine a very volatile asset that goes up 25% one day and down 20% the day after. A perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price:

(1 + 0.25) x (1 – 0.2) = 1

And the perfect leveraged ETF?

(1 + 0.5) x (1 – 0.4) = 0.9

Nothing has changed for the underlying asset, and 10% of your money has disappeared. Beta-slippage is not a scam. It is the normal mathematical behavior of a leveraged and rebalanced portfolio. In case you manage a leveraged portfolio and rebalance it on a regular basis, you create your own beta-slippage. The previous example is simple, but beta-slippage is not simple. It cannot be calculated from statistical parameters. It depends on a specific sequence of gains and losses.

Fred goes on to make the point that is the crux of this article, as follows:

At this point, I’m sure that some smart readers have seen an opportunity: if we lose money on the long side, we make a profit on the short side, right?

## Shorting Leveraged ETFs

Taking his cue from Fred’s article, Seeking Alpha contributor Stanford Chemist (“Shorting Leveraged ETF Pairs: Easier Said Than Done“) considers the outcome of shorting pairs of leveraged ETFs, including the Market Vectors Gold Miners ETF (NYSEARCA:GDX), the Direxion Daily Gold Miners Bull 3X Shares ETF (NYSEARCA:NUGT) and the Direxion Daily Gold Miners Bear 3X Shares ETF (NYSEARCA:DUST).

His initial finding appears promising:

Therefore, investing $10,000 each into short positions of NUGT and DUST would have generated a profit of $9,830 for NUGT, and $3,900 for DUST, good for an average profit of 68.7% over 3 years, or 22.9% annualized.

At first sight, this appears to a nearly risk-free strategy; after all, you are shorting both the 3X leveraged bull and 3X leveraged bear funds, which should result in a market neutral position. Is there easy money to be made?