Averting Disaster: Leverage Limits for Single-Stock Leveraged ETFs

Abstract

Despite some major successes, Leveraged ETFs (LETFs) have resulted in several striking failures that we believe could dramatically increase with the recent introduction of single-stock LETFs in the U.S. Arguing for an urgent need to regulate leverage, we seek to educate regulators, investors, and LETF sponsors as to which single-stock LETFs are likely to be viable and which should be avoided. LETFs suffer from the effects of volatility drag and tail risk. With individual stocks tending to be much more volatile than stock indexes, these two negative factors are considerably amplified in single-stock LETFs and are why so many European single-stock leveraged products have failed. We derive a volatility-based formula for regulating leverage to prevent the toxic mix of high leverage and extreme volatility. We calibrate the parameters of our formula through historical analysis of leverage applied to stocks in the S&P 500. We then demonstrate its effectiveness when applied to the stocks that induced failed European leveraged products. Finally, we apply our framework on a forward-looking basis to stocks in the S&P 500 with comparisons to single-stock LETFs that already trade in the U.S.