UDOW And Leveraged ETFs Dashboard For July

ProShares UltraPro Dow30 ETF (NYSEARCA:UDOW) is a popular instrument to trade in bullish market conditions. However, its daily 3X leverage factor on the Dow Jones is a source of drift, which may be positive or negative. It must be closely monitored to detect changes in the drift regime. This article explains what “drift” means, quantifies it in 22 leveraged ETFs, and reports historical data on UDOW.

Why leveraged ETFs drift

Leveraged ETFs often underperform their underlying index leveraged by the same factor. The decay has essentially four reasons: beta-slippage, roll yield, tracking errors, management costs. Beta-slippage is the main reason in equity leveraged ETFs. To understand what is beta-slippage, imagine a very volatile asset that goes up 25% one day and down 20% the day after. A perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price:

(1 + 0.25) x (1 – 0.2) = 1

In the same time, the perfect leveraged ETF has lost 10%:

(1 + 0.5) x (1 – 0.4) = 0.9

It is not a scam, just the normal behavior of a leveraged and rebalanced portfolio. A good news: in a trending market, beta-slippage can be positive. If the underlying index goes up 10% two days in a row, on the second day, it is up 21%:

(1 + 0.1) * (1 + 0.1) = 1.21

The perfect 2x leveraged ETFs is up 44%:

(1 + 0.2) * (1 + 0.2) = 1.44

Beta-slippage is path-dependent. If the underlying index gains 50% on day 1 and loses 33.33% on day 2, it is back to its initial value, like in the first example. However, the 2x ETF loses one third of its value, instead of 10% in the first case:

(1 + 1) x (1 – 0.6667) = 0.6667

Without a demonstration, it shows that the higher the volatility, the higher the decay.

Monthly and yearly drift watchlist

There is no standard or universally recognized definition for the drift of a leveraged ETF. Some are quite complicated. Mine is simple and based on the difference between the leveraged ETF performance and Ñ times the performance of the underlying index on a given time interval, with Ñ as the leveraging factor. Most of the time, this factor defines a daily objective relative to an underlying index. However, some dividend-oriented leveraged products have been defined with a monthly objective (mostly defunct ETNs: CEFL, BDCL, SDYL, MLPQ, MORL…).

First, let’s define “Return”: it is the return of a leveraged ETF in a time interval, including dividends. “IndexReturn” is the return of a non-leveraged ETF on the same underlying asset in the same time interval, also including dividends. “Abs” is the absolute value operator. “Drift” is calculated as follows:

Drift = (Return – (IndexReturn x Ñ))/ Abs(Ñ)

“Decay” means negative drift.

Click to enlarge

The leveraged bull semiconductors ETF (SOXL) has the worst monthly decay of this list: -0.97%. The highest positive drift in one month is for the bear NASDAQ 100 ETF (SQQQ): +0.84%.

The bull biotechnology ETF (LABU) has the worst 12-month decay (-12.57%), while the bear semiconductors ETF (SOXS) shows the highest positive drift in the same period: 23.62%.

Positive drift follows a steady trend in the underlying asset, whatever the trend direction and the ETF direction. It means positive drift may come with a gain or a loss for the ETF. Negative drift comes with daily return volatility (“whipsaw”). Both bull and bear biotechnology ETFs have negative drifts over the last 12 months, due to sustained volatility in this industry.

UDOW drift history

The next chart plots the 12-month drift of UDOW, starting one year after inception for calculation purposes (02/09/2011).

The average 12-month drift is negative: -1.98%. Nonetheless, the decay was dwarfed by the bullish trend: since inception UDOW has gained 2049% (23.8% annualized)… with a maximum drawdown of -80%! The drift went far in negative territory in the March 2020 meltdown due to whipsaw in the index daily returns. It jumped in positive territory in April 2021, when this bad period went out of the look-back interval. Then, the drift has been mostly negative since February 2022.

Performance over the last 5 years is underwhelming: the 3x leveraged UDOW is slightly lagging the non-leveraged Dow Jones ETF (DIA), due to two volatile periods (the 2020 meltdown and the 2022 correction).

I don’t have a synthetic price series for UDOW before inception, but I have it for ProShares UltraPro S&P500 (UPRO). From 1/1/2000, UPRO would have an annualized return inferior to the non-leveraged S&P 500 (4.86% vs. 7.47%) and a maximum drawdown of -98%. As the Dow Jones has a correlation of 0.96 and a beta of 0.92 relative to the S&P 500 (based on daily returns), performance and risk metrics would be barely better for UDOW.

Some investors think leveraged ETFs will automatically recover when the market goes back up, but it is a misconception. UDOW and other leveraged funds are only for investors and traders with a good understanding of their behavior.