Why Volatility Can Be a Drag for Investors

Note: This article appears on the ETFtrends.com Strategist Channel

By Marc Odo

Read the fine print of the disclosures of a leveraged exchange traded fund (ETF) and you’ll probably come across something like the following:

“This leveraged ETF seeks a return that is +200% or -200% of the return of its benchmark index for a single day.  The ETF should not be expected to provide double or negative twice times the return of the benchmark’s cumulative return for periods greater than a day.”

Wha…?!

This simple disclosure describes an important mathematical property that can have a large impact on investors, but is especially pronounced for those using leveraged ETFs.

The situation being described here is known as volatility drag. Also known as variance drain, volatility drag is the long-term, detrimental impact that volatility has on an investment. Any volatile investment will be subject to volatility drag. But the greater the volatility and the longer the time horizon, the more detrimental the impact of volatility drag tends to be.

Leveraged ETFs, by their very nature, are designed to be more volatile than their underlying investment, so the impact of volatility drag is especially pronounced with leveraged ETFs.

The best way to illustrate the impact of volatility drag is via a simple example.

Let’s say, for example, we have an investment that returns +1% on even number days and -1% on odd numbered days. Setting aside calendar vagaries like weekends, holidays, and the like, let’s assume that the investment alternates between gains and losses of 1% every day it trades. Let’s also assume that we have x2 and x3 leveraged versions of this same investment that will return +2%/-2% and +3%/-3% in the same pattern. At the end of some holding period, what will the final values be?

Simple, back-of-the-napkin math might lead one to conclude that the gains and losses perfectly offset each other and at the end of a year or so the net return for all three alternatives will be zero.