In this Options Jive segment, Tom & Tony ask the Research Team: does the drag effect of Inverse ETFs lose value over the time as it loses the track of its benchmark?
With the current financial markets hitting new highs, traders often look toward inverse ETFs as a means to go short the markets. For example, if a trader were to enter into a position in TZA-- an inverse ETF that simulates a 3x short position in the Russell 2000 ETF (IWM)-- they often expect an inverse, 1.0 correlation. This is not the case, and ultimately they won't profit the way they thought they should be as the correlation breaks down. This is due to the "drag effect."
The Research Team then tested the drag effect of TLT versus TBT (2X Inverse ETF) and IWM versus TZA (3X Inverse ETF).
In the first test, when comparing average TLT movement to the expected TBT movement, the average actual TBT movement had a -0.01% “daily” drag. Over the course of the week, that drag was as high as -0.08%, and over the course of a month, it rose to -0.44%
In the second test, which compared IWM to TZA (3X Inverse ETF), more drastic results were found. The daily drag was -0.03% and the weekly drag was -0.23%, but when looking at the monthly drag, it increased to a hefty -2.98%.
Not only do Inverse ETFs lose track of their benchmark indices because of the “drag effect,” but the longer the Inverse ETF position is held, the worse the average return became. With Leveraged Inverse ETFs, drag effect was amplified as the higher the product’s leverage, the greater likelihood of deviation from the expected return.
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