Leveraged ETF Decay Explained

While the leveraged ETF can fill a need in the day trader’s arsenal or be utilized for a once in a blue moon trend trade, they are certainly not suitable investments for an investor with a time horizon any longer than a week.  Due to the decay in share price value that occurs as a result of daily volatility, both the long and short side of these daily rebalancing acts decay over time, approaching zero regardless of what happens to the underlying sector.
Don’t believe me? Let’s compare how FAS and FAZ performed in the first half of 2009.  They are the 3X Long and Short daily Return ETFs for Financials.  The financial sector ETF XLF as our proxy.  On a daily basis, you can expect FAS to roughly return 3 times the return of XLF and FAZ will return the inverse.

But wait, Surprise!

2009 Performance:

XLF +0.9%
FAS -57%
FAZ -89%
I chose the first half of 2009 for a few reasons.  Most importantly, it demonstrates how the leveraged ETFs perform during a perfectly flat performance for the underlying sector.  You’d think that perhaps they’d be flat as well or perhaps lose an extra percentage point or two due to a higher expense ratio or some tracking error.  No, they completely imploded.  Both of them.
My other reason for this time frame was partially out of laziness and also due to the irony.  I didn’t want to correct for what happened later in July – a reverse split.  Both FAS and FAZ had to undergo a reverse split (this is the “bad” split) and turn shares into more shares because the share prices for each dropped into the single digits.  If that alone doesn’t tell you something about the performance over time…
If you’re insistent upon trying out leveraged ETFs, here’s the full 2X and 3X ETF List.  Alternatively to utilize more leverage (up to X20) while countering the decay factor you can consider another approach trading ETF CFDs, although be aware that many CFD brokerages don’t offer a full range of ETFs as contract for differences.