Leveraged ETFs and Volatility: The 33/22 Strategy

Leveraged ETFs and Volatility:
The 33/22 Strategy

Bradley Powell
bapcap.wordpress.com

April 16, 2009
University of Toronto, RSM330

Leveraged ETFs and Volatility: The 33/22 Strategy
Bradley Powell bapcap.wordpress.com 1
Executive Summary
Leveraged exchange traded funds are unique ETFs that use financial derivatives to produce
heightened investment returns. These funds allow investors to realize double (even triple) the
daily percentage gain or loss of a market index or sector. In the long-term, however, leveraged
exchange traded funds seem to vastly underperform their respective indices after adjusting for
leverage. Three effects are identified as explanations for this phenomenon: the constant leverage
trap, gamma loss, and the lognormal distribution of compounded returns. Market volatility is
found to be the common dynamic force across these effects, and is responsible for creating losses
in leveraged ETFs. Volatility is a complex occurrence that is not easily explained, yet two models
are able to reasonably forecast future realized volatility: the Chicago Board Options Exchange
Volatility Index (VIX) and the generalized autoregressive conditional heteroskedasticity model.
Institutional traders can profit from increased market variability through financial contracts
known as variance swaps. Individual investors, however, are unable to access the over-the-
counter market for these instruments. A trading strategy is therefore proposed that allows
individuals to benefit from increased stock market volatility. The 33/22 Strategy requires an
investor to short sell equal weights of Ultra and UltraShort S&P 500 ETFs when the VIX closes
above 33 and hold this portfolio for 22 days. This strategy can create significant outperformance,
especially during periods of heightened volatility. In the first three months of 2009, a simulated
strategy portfolio made a gain of 3.06% compared to an 11.67% loss in the S&P 500 Index.
Leveraged Exchange Traded Funds
Leveraged exchange traded funds use certain financial instruments to create leveraged
investment results. These instruments include: futures and forward contracts, swap agreements,
and options on securities and indices. As with any leveraged investment, the techniques used by
these ETFs are considerably more aggressive to provide heightened return and risk levels.
Consequently, leveraged exchange traded funds allow investors to realize a multiple of the daily
percentage gain or loss of a market index or sector. Similar ETFs that use short selling allow an
investor to realize inverse multiples of the daily performance of an index or sector. The most
common multiplier is two, yet newer funds attempt to provide returns that are three times that of
the index.
The elevated returns created by these unique exchange traded funds have quickly added to
their popularity and, thereby, their use as investment vehicles. The number of leveraged ETFs has
grown to over one hundred in less than three years while their coverage has been extended from
broad market indices to specific domestic and international sectors. Individual investors are
jumping on the chance to employ leverage in their portfolios. The companies most involved in the
creation of leveraged ETFs include: Direxion, ETF Securities, Horizons Beta-Pro, ProShares and
Rydex.
Although these Ultra and UltraShort ETFs would appear to be viable high-yielding
investment opportunities, they have come under much scrutiny. Many investors are misled by the
objectives of these funds and believe that they will garner multiplied long-term results. In the
long-term, however, leveraged exchange traded funds seem to vastly underperform their
respective indices after adjusting for leverage. To illustrate this, one can examine the performance
of the S&P 500 Index, the ProShares Ultra S&P500 ETF (Ticker: SSO), and the ProShares
UltraShort S&P500 ETF (Ticker: SDS). The ProShares ETFs seek to mimic twice the daily return of
the S&P 500 Index on the long and short end respectively. The performance of the index and
leveraged funds are presented below.
2008 Theoretical Difference
Performance Performance
S&P 500 Index -38.49%
ProShares Ultra S&P500 -67.93% -76.98% 9.05%
ProShares UltraShort S&P 500 60.50% 76.98% -16.48%
The differences between the theoretical and actual performance results of the ETFs are
striking. Management fees and expenses alone cannot explain these tracking errors. There is an
obvious disconnect between indices and leveraged exchange traded funds in the long-term.
Further confusing this anomaly is the fact that most of these funds do generate their investment
goals on a day-to-day basis. Yet this, in fact, is the reason why they do not perform at multiplied
levels over longer horizons. Specifically, three effects cause leveraged ETFs to underperform
theoretical index returns in the long-term: the constant leverage trap, gamma loss, and the
lognormal distribution of compounded returns.
The Constant Leverage Trap
The constant leverage trap is the most well understood cause of underperformance in
leveraged ETFs. This effect was recently highlighted by Yates and Kok in an article for the
SeekingAlpha website. In order to consistently realize doubled daily results, a fund must hold
equal amounts of debt and equity at all times; its leverage ratio must remain constant day to day.
1

Fund managers create leverage through the use of financial derivatives while making an
investment in the underlying index. Stock markets fluctuate daily, however, causing the funds

1
Yates & Kok.
value to move up and down, thereby changing the funds leverage ratio. To correct these
movements, the fund must buy and sell securities each day to rebalance. If the underlying index
makes gains, the equity in the portfolio will increase in value and the fund will be under-leveraged
for the next day. Consequently, the manager needs to buy securities. If the index makes losses, the
situation would be reversed requiring the manger to sell a portion of his position. Inevitably, this
trap means that managers buy when stocks rise and sell when stocks fall. If the underlying index
experiences a period of zero returns yet high volatility, a leveraged fund will actually lose value.
Gamma Loss
Gamma loss describes the losses made by leveraged ETFs as a result of the variance in daily
returns. This effect was explained by Richard Co of the Chicago Mercantile Exchange. The value of
a portfolio holding an ETF with desired leverage | for N days is given by:

V = (1+ |r
i
i=1
N
I
)
This equation can be approximated as:

V ~ (1+ |r )
N
e

1
2
|
2
(1+|r )
2
No
2

where

r is the average daily return for the index during the period and

o
2
is the sample variance
of the daily return.
2
The first term is the compounded returns of the portfolio based on the
average daily performance over the holding period. This is scaled by the second term that has a
value less than 1 due to the negative exponent. From this, it can be shown that during a period of
zero average returns but high volatility, the portfolio will actually decline in value. The magnitude
of this loss is a function of the realized variance and the level of leverage. Richard Co calls this

2
Co, p. 2.
variance-related decline gamma loss. To further prove its existence, Co examines what should be a
self-hedging portfolio that combines equal weights of 2-beta and minus-2-beta S&P 500 ETFs, SS0
and SDS. The portfolio is rebalanced at the end of each month and performance is calculated at
this time. In months of high realized volatility, the portfolio created significant losses attributed to
gamma loss.
Lognormal Distribution of Compounded Returns
The distribution of continuously compounded daily returns is lognormal, not normal. This
less understood effect further undermines the long-run multiplier of leveraged ETFs and has been
clarified by Trainor and Baryla. Compounding causes discrete random returns to become
positively skewed. Over an extended period, the probability distribution function conforms to a
lognormal distribution. One pronounced feature of such a distribution is that the median return is
less than the mean return. This is particularly evidenced with leveraged ETFs as a result of their
higher standard deviations. As variance increases, so does the skewness of the distribution
function. The effect of this over time not only causes expected mean long-run returns to be less
than double, but median returns that is, those at which there is at least a fifty percent chance of
reaching are even less.
3
In fact, Trainor and Baryla found that in the long-term an investment in
a two-times leveraged fund should only expect to attain 1.4 times while doubling its risk as
measured by the standard deviation of returns.
Leveraged ETFs and Volatility
Embedded in each effect is the common enemy of leveraged exchange traded funds:
volatility. It is well understood that day-to-day fluctuations of stock markets are responsible for
creating subtle losses in ETF portfolios. Adding leverage to ETFs, however, vastly magnifies these

3
Trainor & Baryla, p. 50.
losses as explained by the constant leverage trap, gamma loss, and lognormal distribution of
compounded returns. As the volatility of markets increases, so too does the rate at which losses
are incurred. What is even more intriguing is the theory that leveraged ETFs actually add to the
volatility of markets.
4
As Eric Oberg explains, leveraged exchange traded funds are split between
long and short styles. If an investor wants to short an index, he does so by going long in the bear
ETF rather than shorting the bull ETF. Buyers and sellers are purposefully segmented into longs
and shorts creating illiquidity, as they are no longer pricing a common security. By initiating a one-
sided instrument, the market maker is forced to actively hedge his position, which in turn adds
pressure to the underlying index. This is especially the case for short-sided ETFs. Ironically,
leveraged ETFs contribute and magnify the volatility that, in turn, leads to their underperformance
in the long-term.
Volatility is a complex phenomenon that is not merely the result of leveraged ETFs. Defined
as a measure of dispersion around the mean or average return of a security,
5
it is most often
used as an indicator of risk. Broad stock market volatility maintains a strong relationship with
stock market performance. Volatility tends to rise as stock markets decline. Conversely, volatility
eases as markets recover and enter bullish periods. The factors affecting volatility are widespread
yet loosely understood. Explanations for volatility include: macroeconomic variables such as
inflation and interest rates; investor psychology and irrational behaviour; autoregressive
properties; and specific stock trading properties such as dividends and pricing dynamics. All of
these interpretations center around a theory of uncertainty, as it relates to stock markets and the
economy as a whole, however, none fully explain and are able to perfectly forecast volatility.
Significant research has been undertaken in hopes of predicting future volatility. Numerous

4
Oberg.
5
Wagner.
models have been developed, yet two, in specific, are most frequently utilized. The Chicago Board
Options Exchange Volatility Index (VIX) and the generalized autoregressive conditional
heteroskedasticity model are most often used to forecast future volatility in stock markets.
Chicago Board Options Exchange Volatility Index (VIX)
First introduced in 1993, the VIX is the most widely followed measure of near term stock
market volatility. Often referred to as the investor fear gauge, the VIX calculates the 30-day (22
trading days) implied volatility of the S&P 500 Index based on prices of out-of-the-money put and
call options. Implied volatility is the expected volatility of an underlying security or index; it is not
the actual or historical volatility. The VIX does, however, provide a significant prediction of future
realized volatility. Daily VIX closing values from January 2, 1990 to December 31, 2008 were
compared with the standard deviations of returns for the following 22 trading days. The
correlation between these variables was found to be 0.79. This comparison can be found in the
Appendix of this report. The average level and standard deviation of the VIX during this period
were 19.55 and 7.56 respectively. The VIX is efficient in forecasting future volatility because its
calculation implicitly incorporates market participants expectations of uncertainty that are
fundamental to realized volatility.
Generalized Autoregressive Conditional Heteroskedasticity Model (GARCH)
First developed by Robert Engle and Tim Bollerslev, the GARCH model is the most
frequently applied econometric model for predicting future volatility levels in financial markets.
Unlike least squares and ARMA models that focus on the evolution of the mean of a series, GARCH
models attempt to forecast the variance of a series of returns. To do this, it assumed that the best
predictor of the variance in the next period is a weighted average of the long-run average variance,
the variance predicted for this period, and the new information in this period that is captured by
the most recent squared residual.
6
This property allows a GARCH model to incorporate the
volatility clustering that occurs frequently in stock markets into predictions. The predictive power
of GARCH and similar models has been demonstrated in numerous academic publications. In fact,
one study found that model-based volatility forecasts might provide the same, if not better,
forecasts of realized volatility than those determined by the VIX.
7

Variance Swaps
A variance swap is a forward contract in which two parties agree to buy or sell the realized
variance of a certain index or security. The payoff to an investor who enters into a long variance
position is equal to the difference between the realized and strike variance, multiplied by the
notional amount of the swap.
8
A volatility swap is a similar instrument based on the square root
of an assets variance. Variance swaps are more often traded in equity markets due to the fact that
they can be replicated easily with a linear combination of options and futures, making valuation
much simpler.
9
These over-the-counter derivatives can be used to insulate a portfolio against
negative equity market performance. Equity funds are implicitly short volatility. In the short-mid
term, implied volatility and index levels are negatively correlated.
10
Put simply, as markets fall,
volatility increases. An equity investor can use variance swaps to provide diversification and
hedge against equity losses. These products, however, are primarily available only to institutional
and large-scale investors.
Individual investors are unable to gain access to the over-the-counter market for most
variance and volatility swaps. As a result, these investors do not have many opportunities to hedge

6
Engle, p. 159-160.
7
Becker & Clements, p. 132.
8
Kolanovic & Semeraro, p. 1.
9
Biscamp & Weithers, p. 9.
10
Hsu & Murray, p. 367.
against equity losses as they relate to increased volatility. This was highlighted as stock market
volatility skyrocketed during the second half of 2008 while stocks precipitously declined. If an
investor been able to benefit from record levels of stock variability, he would have mitigated the
losses that were incurred in other areas of his portfolio.
Creating a Trading Strategy to Benefit from Volatility
Retail investors do have the ability to short sell securities, however, and as was explained,
leveraged ETFs are inherently prone to sustain losses in the presence of volatility. A trading
strategy could be implemented that exploits these principles. Actually, the framework of such a
strategy has already been presented, in the explanation of gamma loss. Instead of entering into a
long position combining equal weights of 2-beta and minus-2-beta ETFs, an investor can short sell
these Ultra and UltraShort ETFs to benefit from what would now be defined as gamma gain. The
dichotomous construction of the two ETFs would serve as a hedge against most downward
movements because the investor would be in both a leveraged long and short position in the same
index. The index used for the proposed strategy will be the S&P 500, due to its representativeness
of the market and its relation to the VIX, which is crucial in developing the trading rule discussed
later. The leveraged ETFs will be the same used in the gamma loss study: ProShares Ultra S&P500
ETF (Ticker: SSO) and ProShares UltraShort S&P500 ETF (Ticker: SDS). These are among the most
heavily traded leveraged ETFs and would be readily accessible to all investors.
A few considerations must be taken into account before initiating this trading plan. The
strategy is not risk-free. It is possible to make losses given certain conditions on the average daily
return and the variance of daily returns. The gamma gain provided by the strategy is maximized
for all values of variability when the average daily return is zero. However, very rarely is it the
case that markets move sideways for extended periods of time. As the absolute value of the
average daily return moves away from zero, the variance of daily returns must increase to offset
the losses created.
In addition, the length of time before rebalancing must be determined. In order for the
portfolio to benefit from a period of elevated volatility, it must be held for a duration in which the
variance of returns can evolve. If stocks are assumed to be mean reverting, however, this period
cannot be too drawn out, as volatility will recede in the long-term. As well, predictions of the
realized volatility for the period must be made so that the strategy is initiated only when the
chance of heightened return variance is significant. Given that the VIX calculates implied volatility
for the next 22 trading days and GARCH models can be tailored to reliably forecast volatility for
this same period, the duration of the strategys holding period was chosen to be 22 trading days.
The final consideration before attempting this strategy is to develop the trading rule on
which one enters into the position. An investor will want to be confident that the markets will
experience a period, specifically 22 trading days, of heightened volatility. The simplest and most
readily available indicator of future volatility is the VIX. A VIX threshold can be determined such
that, if the VIX surpasses a certain level, the investor will initiate the trading position. Put simply, if
the VIX closes above a certain number on a given day, the investor will create a short position in
SSO and SDS for the next 22 days. If on the day after, the VIX is still above the ceiling level, the
investor will create another, separate, position in the same manner. If the VIX closes and remains
below the trading rule level, the investor will let any outstanding positions close after their 22-day
period has expired.
Backtesting: January 2, 1990 December 31, 2008
In order to identify a threshold VIX level, the strategy was backtested from January 2, 1990
to December 31, 2008. Since the two leveraged ETFs did not exist for the majority of this period,
the daily returns of the S&P 500 Index were doubled to provide a proxy for the daily returns of
SSO and SDS. The strategy returns were then calculated for every 22 trading day period between
1990 and 2008, inclusive. The average return of the strategy over the nineteen years tested was
0.30%; the median was 0.23%. The average and median daily return of the S&P 500 for the same
horizon was 0.03% and 0.05% respectively. Although the strategy requires a holding period of 22
trading days to achieve, it can be implemented anew each day and, therefore, should be compared
to daily S&P returns. The standard deviations of returns for the strategy and the S&P 500 are
2.00% and 1.14% respectively. An investor could further add to the returns of this strategy at no
additional risk by using the proceeds from short sales to purchase one month T-bills. The
backtested returns of the trading strategy are presented in the Appendix of this report.
The outperformance of this strategy, even after adjusting for risk, is apparent without a
trading rule. Yet, the returns in this scenario do not consider trading expenses from commissions
and short selling. The goal of backtesting was to find a VIX threshold at which an investor can be
reasonably assured that he will create significant outperformance. Intuitively, this level will be at
the point where, the correlation between the closing VIX values above the threshold and their
corresponding 22-day strategy returns is the highest. It was found that this value is approximately
33 and that the correlation between VIX values and strategy returns is 0.69. (As well, 33 is roughly
equal to the mean VIX value plus 1.75 standard deviations, meaning that about 95% of values are
lower than this ceiling.) For simplicity, GARCH models were not used to craft the trading
threshold, yet their use, as well as an investors sheer intuition, would serve to hone the conditions
in which the proposed strategy is executed. By setting 33 as the trading rule, the mean and median
strategy returns are 3.40% and 1.78% respectively with a standard deviation of 6.89%. The
backtested returns, of what will be referred to as the 33/22 Strategy, are presented in the
Appendix of this report.
Testing the 33/22 Strategy: January 2, 2009 March 31, 2009
The 33/22 Strategy was tested out-of-sample for the first quarter of 2009. During this
period, the VIX remained above 33 as stock markets continued to decline and experience
unprecedented levels of volatility. The Rotman Portfolio Manager was unable to provide a suitable
platform to test the proposed strategy. Given that a new equally weighted SSO and SDS short
position was needed daily, but rebalancing occurs only every 22 days, a total of twenty-two
accounts would have been required. Therefore, the same method that was used to backtest the
strategy, was used analyze present-day returns. Over the course of Q1 2009, the average return of
the 33/22 Strategy was 1.44%, the median return was 3.28%, and the standard deviation of
returns was 5.24%. This is compared to the S&P 500 Index with corresponding data of -0.17%, -
0.05%, and 2.64% for daily returns. If an investor began 2009 with $22,000 and invested this
money in the S&P 500 Index, by March 31, 2009 he would have lost $2566.69 (-11.67%) for an
ending portfolio value of $19,433.31. If that same investor had split his initial investment into
twenty-two accounts of $1,000 each and initiated a 33/22 Strategy, short selling no more than the
value of the account and investing the proceeds and the existing cash at the average T-bill rate, he
would have made gains of $673.39 (3.06%) for an ending portfolio value of $22,673.39. The gains
made from the 33/22 Strategy, overwhelmingly exceed the losses incurred by the S&P 500 Index.
The above example, however, does not include trading costs, assumes that the leveraged ETFs can
perfectly double index returns, and presupposes that the investor does not suffer currency
exchange losses it is a purely theoretical example. Further analysis of these inhibitory factors is
necessary before pursuing this trading strategy in a real world setting. Nevertheless, the
significance and possibility for outperformance of the 33/22 Strategy is emphasized. By initiating
the proposed 33/22 Strategy that benefits from gamma gain in volatile markets, an investor has
the potential to drastically outperform underlying indices.
Conclusion
Leveraged ETFs are incredibly alluring to the average investor who thinks he can create
sizeable gains and vastly outperform the market. These securities, however, are not as simple as
they seem. In fact, they are problematic in the long-term. Volatility drastically impacts the
multiplied returns that leveraged ETFs attempt to provide. An in depth analysis of these funds was
provided to serve as a foundation for creating a strategy in which individual investors can benefit
from market volatility. The 33/22 Strategy was presented based on backtested results from 1990
to 2008. In the first quarter of 2009, the simulated strategy generated significant returns over the
S&P 500 Index. Although the theoretical example did not take into consideration trading costs, it is
likely that the strategy would still offer profits after their inclusion.
Appendix
VIX Predictive Ability
January 2, 1990 December 31, 2008
correlation = 0.789
0
0.01
0.02
0.03
0.04
0.05
0.06
0 10 20 30 40 50 60 70 80 90
VIX
2
2

D
a
y

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

o
f

S
&
P

5
0
0

D
a
i
l
y

R
e
t
u
r
n
s

Historical Strategy Return vs. Market Volatility
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0 0.01 0.02 0.03 0.04 0.05 0.06
22 Day Standard Deviation of S&P 500 Daily Returns
S
t
r
a
t
e
g
y

R
e
t
u
r
n

VIX vs. Historical Strategy Returns
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0 10 20 30 40 50 60 70 80 90
VIX
S
t
r
a
t
e
g
y

R
e
t
u
r
n

Historical Returns of the 33/22 Strategy
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
20 30 40 50 60 70 80 90
VIX
S
t
r
a
t
e
g
y

R
e
t
u
r
n

33/22 Strategy Returns
January 2, 2009 March 31, 2009
-0.15
-0.10
-0.05
0.00
0.05
0.10
30 35 40 45 50 55 60
VIX
S
t
r
a
t
e
g
y

R
e
t
u
r
n

References
Historical levels for the S&P 500, VIX, SSO, and SDS were taken from Yahoo! Finance.
Becker, Ralf, and Adam E. Clements. Are combination forecasts of S&P 500 volatility statistically superior?
International Journal of Forecasting. 24 (2008): 122-133. ScienceDirect. < http://www.sciencedirect.com>
Biscamp, Lewis, and Tim Weithers. Variance Swaps and CBOE S&P 500 Variance Futures. Euromoney Handbooks. 5-
12. Chicago Board Options Exchange. < http://cfe.cboe.com/education/finaleuromoneyvarpaper.pdf>
Co, Richard. Leveraged ETFs vs. Futures: Where is the Missing Performance? (9 February 2009). CME Group.
<http://www.cmegroup.com/trading/equity-index/files/Leveraged_ETFs.pdf>
Engle, Robert. GARCH 101: The Use of ARCH/GARCH Models in Applied Econometrics. Journal of Economic
Perspectives. 15.4 (2001): 157-168. <http://pages.stern.nyu.edu/~rengle/Garch101.doc>
Hsu, Stephen D.H., and Brian M. Murray. On the volatility of volatility. Physica. 380 (2007): 366-376. ScienceDirect.
<http://www.sciencedirect.com>
Kolanovic, Marko, and Gary Semeraro. Variance Swaps: An Introduction. Bear Stearns Equity Derivatives Strategy. (7
April 2005). Bear Stearns.
<http://www.classiccmp.org/transputer/finengineer/%5BBear%20Stearns%5D%20Variance%20Swaps%2
0-%20An%20Introduction.pdf>
Oberg, Eric. Why Short Sector ETFs Arent So Smart. TheStreet.com. (23 December 2008).
<http://www.thestreet.com/story/10454678/why-short-sector-etfs-arent-so-smart.html>
Trainor, William J., and Edward A. Baryla. Leverage ETFs: A Risky Double That Doesnt Multiply by Two. Journal of
Financial Planning. (May 2008): 48-55. EBSCOhost Business Source Premier. <http://www.ebscohost.com>
Wagner, Hans. Volatilitys Impact on Market Returns. Investopedia.com.
<http://www.investopedia.com/articles/financial-theory/08/volatility.asp>
Yates, Tristan, and Lye Kok. The Case Against Leveraged ETFs. SeekingAlpha. (17 May 2007).
<http://seekingalpha.com/article/35789-the-case-against-leveraged-etfs>

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