Beyond Volatility Decay: Correcting Relative Expected Return Estimates for Leveraged Exchange Traded Funds

Leveraged exchange traded funds (LETFs) magnifying popular index daily returns by up to ±3.0× are often assumed to belong in the domain of sophisticated traders with short-term horizons. This study shows why the standard method used by LETF providers to inform investors of long-run expected returns relative to an underlying index produces estimates that significantly deviate from statistically correct returns given a particular index return and standard deviation. Current methods underestimate LETF expected returns by over one hundred percentage points annually for bullish LETFs during high-return/high-volatility environments and equally overstate bearish LETFs’ performance during negative-return/low-volatility environments. These errors are magnified with higher leverage. The statistically correct method is also applied to monthly and quarterly calendar LETFs, showing they outperform daily LETFs in average- to high-volatility environments while daily LETFs tend to outperform in high-return, low-volatility environments. Results have implications for portfolio management, fund providers, regulators, and investors using LETFs for longer-term horizons while challenging the idea that LETFs are purely short-term trading vehicles.