How Leveraged ETFs Really Work (Marco Sammon & Chirs Murray)

Benjamin Felix (0:04)

Welcome to Episode 432 of The Rational Reminder Podcast. We're hosted by me, Benjamin Felix, Chief Investment Officer and Portfolio Manager at PWL Capital.

Dan Bortolotti (0:12)

And I'm Dan Bortolotti, Portfolio Manager at PWL Capital.

Benjamin Felix (0:16)

And today we are joined by Chris Murray and Marco Sammon for a fascinating conversation. Chris earned a master's degree in machine learning from Carnegie Mellon University in 2007 He then spent over a decade working as an equity quant and trader at Goldman Sachs and JP Morgan. In 2023, he joined GECO as the head of trading. It's a bank that uses US Treasury bills to offer a safe yield generating alternative to traditional cash management.

It's just an interesting side note. We don't talk about anything related to that.

And then in that same year, he started working as a researcher at Harvard Business School with Marco Sammon. Marco has been a guest in this podcast twice in the past. He's an assistant professor in the finance unit at Harvard Business School. We talked to them, Dan, about leveraged ETFs.

Dan Bortolotti (1:06)

Yeah, this one was a real deep dive. But I think everyone's going to enjoy this one because both Marco and Chris are just so articulate at describing what are some pretty complex ideas, but a lot of insights in their papers. And I think we really teased out a lot of things from them during the discussion.

Benjamin Felix (1:23)

So warning before you get into listening to this one, it's up there with the nerdiest episodes we've ever done. Some of it, Dan, you and I were chatting earlier, it went over our heads too. So I mean, do your best as you listen through. It was clear that for some of the conversation, Marco and Chris were talking to regular people, but for portions of it, they were definitely talking to other researchers, which is interesting to listen to. But I mean, I guess I'm just saying if it goes over your head, don't feel too bad and stick around at the end to hear Dan and I give our thoughts in the conversation. But for now, let's go ahead to our episode with Marco and Chris.

Marco Sammon and Chris Murray, welcome to The Rational Reminder Podcast.

Marco Sammon (2:04)

Thanks so much for having me back on.

Benjamin Felix (2:06)

Welcome to Georgia. Yeah, very nice to have you back. Marco and Chris, super excited to be talking to you for the first time.

You guys wrote a very nerdy paper. I'm pretty sure I'm comfortable saying that this might be one of the nerdiest episodes we've ever done, but we'll let us speak for itself. To start off guys, how do LETFs or Leveraged ETFs work?

Chris Murray (2:25)

Fantastic question. As people probably know, if they read the prospectus, Leveraged ETFs target a multiple of the daily return of a stock or an index. They aren't trying to get 2X the annual return, they're trying to get 2X the daily return. One of the nuances of this is that this isn't free. There are benefits to this and there are costs to this.

When they're doing this, they have to borrow to get their leverage. Leverage isn't something you can get for free. The extent to which leverage isn't free is related to borrowing rates. As most of you listeners probably know, borrowing rates have gone up pretty substantially in the last few years relative to what they were through a lot of our sample. That's one of the points that we'll talk on later. Usually, what they do is they enter into a swap with a large bank to get that leverage. If I'm a 2X leverage ETF, I'm not sitting there holding the actual underlying stock, I have a swap with the bank, and if my ETF has 100 million of assets, I have a swap for 200 million of the underlying asset.

I'm going to rebalance that swap every day against the bank to make sure that I can maintain my target leverage ratio.

Dan Bortolotti (3:30)

Now, how significant have these leverage ETFs become in the US ETF market now?

Chris Murray (3:36)

They're big, but they're not massive. If I was going to compare them to something like index funds or mutual funds, they're not even close. They definitively are not there, but they have grown a lot. In the data set we were looking at, they're a little bit over $100 billion, which is real, but for the US market, that's not too massive. Where they've been growing, the interesting thing is, it's not the vanilla index ones, it's the single stock, it's the crypto, it's the hairy stuff. That's what's been taking off recently.