Abstract The large deviation of the actual return of a leveraged exchange-traded fund (LETF) from the leveraged multiple of the underlying index return has drawn considerable attention from investors, regulators, and the financial media. Despite this attention, the sources and fundamental determinants of the LETF return deviation remain unidentified. This study constructs a clear, unified, objective, and executable framework that addresses the behaviors, sources, and determinants of the LETF compounding and noncompounding deviations. Our theoretical predictions and empirical results hold the promise of guiding investors, regulators, financial advisors, and portfolio managers toward a thorough understanding of the return behavior of LETFs.

Using the longest history of a U.S. equity market index, this paper simulates the return deviation and multiple deviation for Leveraged Exchange-Traded Products (LETPs) with different rebalancing frequencies, including daily, monthly, annually, and every five years, over various holding periods. We find that the general perception that daily-rebalanced LETPs are not suitable for long-term strategies is not substantiated. Advancing the analysis, we construct a comprehensive framework that determines the deviation of an LETP’s effective multiple from its stated product multiple under various rebalancing frequencies and holding period scenarios. The empirical framework and results from this paper hold the promise of guiding regulators, policy makers, and investors in their understanding of the tracking performance of LETPs.