Risk comparison between leveraged and non-leveraged funds : an analysis of risk relative to the leverage being utilised

Abstract

This study attempts to determine whether the returns of leveraged funds are affected by external risk factors that do not affect the returns of conventional funds. Various experts in the fund Financial industry have differing views on the risk of leveraged funds. Some experts believe that leveraged fund returns are affected by external risk factors that do not affect conventional funds. Others believe that leveraged funds can use tools that are not used by conventional funds to decrease the fund’s risk. Naturally, leveraged funds will always be riskier than conventional funds. This study aims to determine whether leveraged funds are affected by external factors which increase their risk separate from the leveraging factor. To carry out this test, two portfolios were created – a Leveraged ETF Portfolio and a Conventional ETF Portfolio. Then, the following risk metrics of these portfolios were obtained and compared: 1. Beta 2. Standard Deviation 3. Sharpe Ratio 4. Treynor Ratio 5. ETF Drift These risk metrics were chosen with the aim of covering several aspects of an ETF’s risks and thus obtain a full understanding of their risk profile. Statistical tests were also carried out to verify the statistical significance of the risk comparison results and find whether these results are statistically different from each other. The risk comparison test yielded similar results for both the portfolios apart from the Treynor Ratio risk metric, which indicated that conventional funds have a slightly better risk-adjusted return than leveraged funds. These results denote that, when considering the leveraging factor, leveraged funds have a similar risk profile to conventional funds. The results from the statistical test indicate that the risk metrics of both portfolios are statistically similar. These results contradict the experts whose are of the opinion that leveraged funds are affected by external risk factors which increase or reduce their risk compared to conventional funds. Investors who are considering investing in leveraged funds can feel assured knowing that their investment would not be adversely affected by external factors.