Volatility Decay

Volatility Decay (also known as volatility drag) is a subtle but powerful force that erodes the value of certain investment products over time, especially leveraged ETFs and inverse ETFs. Think of it as a hidden tax on your returns that gets worse the more the market bounces around. These products are designed to deliver a multiple (like 2x or -1x) of an underlying index's performance on a daily basis. Because they reset their leverage every single day, the mathematics of compounding works against the long-term holder. In a choppy, sideways market, the underlying index might end up back where it started after a few weeks, but the leveraged product tracking it will have lost value. This “decay” isn't due to fees or poor management; it's a structural flaw inherent in how these instruments are built, making them fundamentally unsuitable for the buy-and-hold strategies favored by value investing.

Imagine you're watching a thrilling but bumpy car race. Volatility decay is like losing a bit of fuel every time the car speeds up and then has to brake hard, even if it ends up back at the same spot on the track. Let's put some numbers to it. Suppose you invest in a 2x leveraged ETF that tracks the S&P 500.

• You start with $100 in the ETF, and the S&P 500 is at 10,000 points.
• Day 1: The S&P 500 has a great day, rising 10% to 11,000. Your 2x ETF is designed to deliver double that return, so it jumps 20%, and your investment is now worth $120. So far, so good!
• Day 2: The market gives back its gains. The S&P 500 falls back to 10,000. This is a drop of approximately 9.1% from its new high of 11,000.
• Here's the catch: Your 2x ETF now has to fall by double that percentage, so it drops by 18.2% (2 x 9.1%).
• Your new value is $120 - (18.2% of $120) = $120 - $21.84 = $98.16.

The S&P 500 index is right back where it started, but your investment has decayed to $98.16. This small loss, repeated over weeks and months of market ups and downs, can devastate a long-term holding.

This phenomenon is the arch-nemesis of anyone trying to use leveraged or inverse products for long-term investing. These tools are explicitly designed for short-term traders and speculators who want to make a highly targeted bet on the market's direction over a few hours or days.

• Day Traders: A day trader might use a 3x leveraged ETF to magnify a gain on a single day's expected news event. They buy in the morning and sell in the afternoon, so volatility decay over multiple days is irrelevant to them.
• Long-Term Investors: An investor who buys the same product and holds it for a year, hoping to get 3x the annual return of the market, is in for a rude awakening. The daily resetting and the constant market volatility will almost certainly ensure their final return is far lower than they expected, and they could even lose money in a market that went up.

For a value investor, volatility decay is more than a mathematical curiosity; it's a lesson in what not to do. Value investing is about owning a piece of a real business and benefiting from its long-term growth in profits and intrinsic value. It's about patience, not gambling on short-term price wiggles.

• Focus on Business, Not Bets: Warren Buffett famously advised investors not to buy anything they wouldn't be perfectly happy to hold if the market shut down for ten years. Could you imagine holding a 2x leveraged ETF for a decade? The decay would likely wipe out most of your capital, regardless of what the underlying index did. In contrast, holding a low-cost index fund means you own the actual shares of the underlying companies. Your fortune is tied to their real-world success.
• Volatility: Friend or Foe?: Value investors see market volatility as an opportunity—a chance to buy great companies when they are temporarily on sale. Leveraged ETFs, however, are punished by volatility. The very thing a savvy investor uses to their advantage becomes a destructive force for these trading products.

In short, volatility decay is a stark reminder to invest in businesses, not in complex financial products that try to outsmart the market with daily resets. Stick to owning durable, profitable companies—either directly or through a simple fund—and let the magic of real compounding, not the voodoo of daily leverage, work for you over the long run.