A leveraged Exchanged Traded Fund (LETF) is a financial instrument designed to deliver a multiple of the daily return of an underlying index. Despite criticism, LETFs are frequently used by institutional investors. In this post, I discuss the practicality of LETFs and show that they are not as risky as they may seem.
Information Content of Leveraged ETFs Options
Leveraged ETFs, or exchange-traded funds, are investment funds designed to amplify the returns of an underlying index or asset class through the use of financial derivatives and debt. These ETFs aim to achieve returns that are a multiple of the performance of the index they track, typically two or three times (2x, 3x) the daily performance.
There is evidence that 1x ETF options provide an indication of the future return of the underlying 1x ETF. Reference [1] goes further and postulates that options on leveraged ETFs provide an even stronger indication of the 1x ETF future return.
Findings
-Options on leveraged ETFs provide stronger predictive signals for future ETF returns compared to standard ETF options, showing higher economic and statistical significance.
-The study uses unexpected changes in implied volatility from call and put options on leveraged ETFs to identify signals of informed trading activity.
-Leveraged ETF option signals consistently outperform unleveraged signals in predicting future returns of the underlying ETFs across various market conditions.
-Sophisticated investors often trade leveraged ETFs for exposure and rely on their options markets to hedge or speculate based on market expectations.
-A $1 investment in SPY based on leveraged option signals would have generated $27.59 in net returns from 2009 to 2021 after transaction costs.
-The predictive power of leveraged ETF option signals is especially strong during economic downturns, making them useful in volatile or declining markets.
-Inverse leveraged ETFs provide particularly strong predictive signals, especially when markets are trending downward or experiencing negative momentum.
-A trading strategy based on leveraged ETF option signals produced average abnormal returns of 1.13% per month, even after accounting for transaction costs.
-The findings suggest that options on leveraged ETFs play a key role in market efficiency and price discovery by reflecting informed investor activity.
-Both leveraged and unleveraged ETF options contain return-predictive information, but the economic impact is far greater when using leveraged ETF option signals.
In short, by using the difference in implied volatility innovations between calls and puts of leveraged ETFs as a trading signal, one can gain excess returns.
Reference
[1] Collin Gilstrap, Alex Petkevich, Pavel Teterin, Kainan Wang, Lever up! An analysis of options trading in leveraged ETFs, J Futures Markets. 2024, 1–17
Leveraged Exchange Traded Funds Revisited: Enhancing Returns or Adding Risk?
LETFs have received a lot of criticism. Despite the controversy, they remain popular among institutional investors. Reference [2] revisited the use of LETFs in portfolio allocation.
Findings
-LETFs aim to deliver amplified daily returns using derivatives and debt, making them suitable for short-term tactical strategies but requiring careful risk management.
-The study shows LETFs exhibit call option–like payoff characteristics, suggesting they can offer inexpensive leverage with built-in downside protection in certain scenarios.
-Under ideal conditions like continuous rebalancing and no constraints, the authors derived a closed-form information ratio–optimal strategy that followed a contrarian investment approach
-In realistic market conditions, including quarterly trading and margin constraints, a neural network approach was used to identify performance-optimized LETF allocation strategies.
-Results showed that unleveraged strategies using LETFs outperform benchmarks more frequently than leveraged strategies using standard (vanilla) ETFs on the same index.
-These unleveraged LETF strategies also showed partial stochastic dominance over both the benchmark and vanilla ETF-based strategies in terms of terminal wealth outcomes.
-The neural network–based strategy, trained on historical market data, further supports the practical value of including LETFs in actively managed portfolios.
-The findings challenge the common belief that LETFs only serve short-term speculation, revealing potential for long-term, dynamically optimized investment use.
-Overall, incorporating LETFs through informed strategies can enhance risk-adjusted returns, outperform traditional benchmarks, and improve the robustness of portfolio performance.
An interesting finding of this study is that, through a closed-form solution and numerical simulations, the authors demonstrated that LETFs behave like call options. Based on this, it is intuitive that if LETFs are part of a portfolio, they can enhance risk-adjusted returns.
Reference
[2] Pieter van Staden, Peter Forsyth, Yuying Li, Smart leverage? Rethinking the role of Leveraged Exchange Traded Funds in constructing portfolios to beat a benchmark, 2024, arXiv:2412.05431
Closing Thoughts
In conclusion, both studies provide compelling evidence that leveraged ETFs and their options hold significant value beyond short-term speculation. Leveraged ETF options offer strong predictive signals that can enhance trading strategies and market insight, while actively managed LETF allocations can improve long-term portfolio performance. When used thoughtfully, these instruments can deliver meaningful returns, manage risk, and contribute to price discovery.