Volatility Decay

Volatility Decay is also known as beta slippage or path dependency and is a mathematical phenomenon that affects all investments, but is particularly noticeable in leveraged ETFs.

The concept is often misunderstood and used as a the argument to avoid leveraged ETFs. In this guide, we'll explain what it is, how it works, and why it shouldn't be looked at in isolation.

The Basic Principle

When you're looking at a compounding investment, the order of returns matters more than the average return.

Let's start with a simple example using a regular (non-leveraged) investment:

Scenario: +25% followed by -20%

Initial Investment: $100.00

After +25%: $125.00 (Gain: $25.00)

After -20%: $100.00 (Loss: $25.00)

Average Daily Return: +2.5% ((+25% - 20%) ÷ 2)

Actual Total Return: 0%

Despite having a positive average daily return of +2.5%, the investment ends up exactly where it started. This demonstrates a fundamental principle: when dealing with percentage gains and losses, the sequence of returns matters more than the average return. Yep, we repeated that sentence. Because it is essential to understand.

Interactive Example

Experiment with different parameters to how they affect volatility decay.

Leverage Factor

Daily Move

Number of Days

Performance Comparison

2x Leveraged ETF
Underlying Index

Underlying Return

-39.50%($60.50)

Leveraged Return

-87.01%($12.99)

Key Takeaways

What Volatility Decay Is

A mathematical result of compounding returns
Affects all investments, not just leveraged ones
More pronounced with higher volatility
Amplified by leverage

What Volatility Decay Isn't

Not a "cost" or fee
Not unique to leveraged ETFs
Not a standalone reason or argument to avoid leveraged ETFs entirely

Next Steps

Now that you understand volatility decay, you might want to: