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Due to the interplay between daily rebalancing and volatility, Leveraged Exchange Traded Funds (ETFs) may experience a cumulative return different from the product of their daily leverage ratio and the periodic index return. When the leveraged ETF’s return over a particular time frame minus the leverage ratio of the ETF multiplied by the underlying index return is negative, we refer to it as decay. The quantity of this decay is influenced by the daily leverage ratio, time, index return, and volatility. This study quantifies the tradeoffs these variables have on decay, and derives maximum holding periods given an investor's decay threshold under various volatility environments. While the majority of studies suggest short holding periods for leveraged ETFs, this paper asserts that extended holding periods can be justified depending on volatility levels and an investor's willingness to accept a certain level of decay. For decay thresholds of only -2% and low volatility levels, holding periods beyond 6 months can be justified for some leveraged funds. Empirically, forecasted decay over a 3-month period based on the Russell 1000 and using a GARCH (1, 1) volatility estimate rarely underestimates actual decay. Through 2007, the average justified holding period for all but the -3x fund generally exceeded 4 months. During the financial crisis, justified holding periods decreased dramatically.

Forecasting Holding Periods for Leveraged ETFs Using Decay Thresholds: Theory and Applications