UGL Drift And Leveraged ETF Watchlist #NewsETFs

The ProShares Ultra Gold ETF (NYSEARCA:UGL) magnifies gold price return for trading purposes. However, leveraged funds may be subject to decay. This article explains drift, reports it for 22 leveraged ETFs, and focuses on UGL.

Why do leveraged ETFs drift?

Leveraged ETFs often underperform the underlying asset leveraged by the same factor. The decay has essentially four reasons: beta-slippage, roll yield, tracking errors, management costs. 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

And the perfect leveraged ETF?

(1 + 0.5) x (1 – 0.4) = 0.9

Nothing has changed for the underlying asset, and the ETF price is down 10%. It is not a scam, just the normal behavior of a leveraged and rebalanced portfolio. 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 ETF 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. Hence, its name: “beta” is a statistical measure of volatility. However, it is a bit misleading because the decay cannot be calculated from beta.

Drift watchlist

There is no standard definition of leveraged drift. Mine is based on the difference between the leveraged ETF return and Ñ times the return of the underlying index over a time interval, if Ñ is the leveraging factor. This factor usually defines a daily objective relative to an underlying index. However, some leveraged products have been defined with a monthly objective, mostly defunct dividend-oriented ETNs. Some definitions are needed:

• “Return” is the return of a leveraged ETF in a given time interval.
• “IndexReturn” is the return of a non-leveraged ETF on the same underlying in the same time interval.
• “Abs” is the absolute value operator.
• “Drift” is the drift of a leveraged ETF normalized to the underlying asset exposure in a time interval. It is calculated as follows: Drift = (Return – (IndexReturn x Ñ))/ Abs(Ñ)
• “Decay” means negative drift.

Click to enlarge

The 3x bull semiconductors ETF (SOXL) shows the worst monthly decay of this list (-2.21%), and it has also suffered the largest 12-month decay (-15.46%).

The highest positive drift in one month is 0.49% for the 2x bear gold ETF (GLL). Several ETFs have a 12-month positive drift above 10%: SDS, SPXU, SQQQ, GLL, SOXS.

Positive drift comes with a steady trend in the underlying asset, whatever the trend direction and the ETF direction. Indeed, positive drift may come with a gain or a loss for the ETF. Negative drift results from the alternation of positive and negative daily returns (“whipsaw”). For example, leveraged ETFs in semiconductors (bull and bear) show a significant monthly decay, because stock prices in this industry have been volatile lately.

UGL shows a moderate negative drift on both time frames.

UGL drift history

Since its inception on 12/1/2008, UGL has gained 254% (8.36% annualized), while the spot gold ETF GLD is at +206% (7.35% annualized) in the same time. Additionally, UGL had a maximum drawdown of -76% vs. -46% for GLD. The ratio of total returns (1.23) is far below the daily leverage factor, while the ratio of maximum drawdowns is closer to it (1.65). The comparison of risks and rewards is not really favorable to UGL.

The next chart plots the 12-month drift since December 2009.

The drift was negative most of the time and its average is about -2%. Periods of positive drift came after steady trends with little daily whipsaw: 2011 (uptrend), 2013 (downtrend), 2020 (uptrend). Gold has been in a strong bull market since November 2022, but the drift has stayed in negative territory. This may be partly due to the alternation of positive and negative daily returns, but also to another drift factor: roll yield. UGL doesn’t create leverage by borrowing money, but by holding futures and swap contracts. Gold is in a contango market now: contract prices increase with duration, which means rolling them has a cost.

Takeaway

ProShares Ultra Gold ETF is a good swing trading instrument for short-term bets on gold. However, it has suffered a significant decay on the long term. The 12-month drift of UGL has been continuously negative since June 2020, despite the current bull market in precious metals. Gold is in a contango market, which is an additional factor of decay. Leveraged ETFs are designed for seasoned investors with a good understanding of their behavior. In doubt, stay away from them.