Leveraged ETF returns smoothed by shorter holding periods

Returns on leveraged ETFs do not fluctuate as much compared to short ETFs without leverage, when held for shorter time periods according to Deutsche Bank.

Research conducted by Constance University of Applied Sciences, on behalf of db x-trackers, shows returns on leveraged ETFs were not as volatile as expected, even though the leverage function implied returns would fluctuate far more.

The university's professor of business administration Leo Schubert, who headed the study, says: "The significantly shorter holding period of ETFs with higher leverage seems to be at the bottom of this."

The analysis looked at the use of short - or inverse - ETFs and leveraged ETFs in Germany, Europe's largest market.

Results reveal holding periods are quite short for inverse and leveraged ETFs, and show the amounts usually invested in leveraged products are significantly lower than non-leveraged funds.

The study deduces this conservative behaviour implies investors understand the path dependent nature of short and leveraged ETFs.

Schubert says: "The results imply that in the majority of cases the private investors subject to the study seem to be aware of the majority of risks and opportunities connected with the use of short and leveraged ETFs."

The results show after 15 days, around 50% of these ETFs have been sold again. This figure rose to 85% after three months. It shows 50% of trades were also far less than €5,000. Investment volume also tends to drop as the holding period increases.

Db x-trackers head Thorsten Michalik says: "We've taken the criticisms of short and leveraged products seriously. This study suggests that users of the short and leveraged ETFs have a good understanding of these products and the main risks inherent to them."

Short and leveraged ETFs are path dependent, as they reset on a daily basis, meaning open positions compound daily performance across days. Consequently, ETFs that say they deliver two times the index performance do so only on a daily basis, rather than over longer time periods.

As a result, some investors who were unaware of how this compounding worked, or were mis-sold the products, were subsequently burned. A number of brokerage houses suspended their purchase of such funds over the last couple of years and these products have come under scrutiny from regulators in different jurisdictions.

In June 2009, the Financial Industry Regulatory Authority (Finra) in the US released a notice on short and leveraged funds, warning that intermediaries need to be aware of the risks involved and that recommendations of these products to investors must be suitable, based on a "full understanding."

Deutsche Bank's study is based on data from major brokerage houses in Germany. A total of 26,394 purchase and subsequent sales of short and leveraged ETFs between 1 January 2008 and 1 April 2010 were studied.

During this time, investors traded in 39 different types of short and leveraged ETFs from six different providers.