Can shorting leveraged exchange-traded fund pairs be a profitable trade?

George Tsalikis and Simeon Papadopoulos

Abstract

In this paper, we examine if investors can profit from the underperformance of leveraged exchange-traded funds (ETFs) in long holding periods. One strategy involves shorting equal amounts of positive and negative leveraged ETFs that follow the same benchmark in order to obtain volatility decay as profit. The profitability of this strategy is independent of the direction of the underlying index. A theoretical frame- work is presented regarding the conditions under which this strategy can be profitable. When empirically tested for two years in four S&P 500 leveraged ETFs for monthly holding periods, this strategy produced a profit for both the ˙2 and the ˙3 pairs. However, after considering shorting fees for the funds, the profitability of this strategy for both pairs was highly diminished. We also examine a different method of going long in an index by shorting bear funds and compare this with purchasing bull funds for the same period. When empirically tested for two years in four S&P 500 leveraged funds for monthly holding periods, shorting the bear funds produced slightly higher average profits and risk-adjusted returns than going long the bull funds, even after accounting for shorting fees.