Leveraged and inverse funds work best when three things happen:
- You call the market direction correctly
- Momentum is in your favor, with daily moves in the same direction
- Moves are consistent and spread out over time
Bush and Brown focused on condition No. 3, with good reason. All else being equal, a slow, steady path allows the pro-cyclicality of leveraged ETFs to work in your favor, assuming you got the direction right.
To illustrate condition No. 3, let's add index C to our series. Index C starts at 100 and ends at 110, just like A and B, but takes a slow and steady path to get there. Index C's daily standard deviation is a minuscule 0.06 percent compared with A and B's 4.47 percent.
The contrast in returns between paths A and B versus C is dramatic.
Slow and steady wins this race.
The takeaway: For levered and inverse funds, volatility matters, but so does the path your index travels. Make sure you have clear expectations for all three of the factors that influence returns before you enter into a path-dependent investment.
P.S. Path dependency sometimes affects ETN fees, too.
Contact Elisabeth Kashner at [email protected].