LETFs: Harvesting Decay With Two LETFs

[WITH CODE] Evaluating the performance of 'Dual Short' vs. 'Short Bear' strategies in a high-interest rate regime.

Hello!

Welcome back to another market investigation. Today, we will be building upon our prior post, LETFs: Strategy to Harvest Decay, by covering potential pitfalls and showing how we can improve the overall strategy.

I’ll first cover some research papers that are directly applicable to the strategy that we test in this post. Then, I’ll showcase the backtests that I ran and how we can optimally harvest the decay in LETFs that stems from volatility and interest rates.

Let’s get into it.

---

Research Insights: Dual LETF Shorts

To understand the mechanics of volatility trading, we examined two foundational papers that analyze Leveraged ETFs (LETFs). While both study the same assets, they reach fundamentally different conclusions on how to trade them.

Paper 1: Investment Performance of Shorted Leveraged ETF Pairs¹

Jiang and Peterburgsky (2013) propose that shorting leveraged ETF pairs is a highly profitable strategy that exploits volatility decay. By simulating returns over a 48-year period, they argue that shorting a triple-leveraged bull ETF and a triple-leveraged bear ETF simultaneously creates a market-neutral portfolio. Their results suggest this approach (specifically using a 2:1 ratio) significantly outperforms the S&P 500 with a high Sharpe ratio, provided the cash proceeds are invested in Treasuries.

Paper 2: Investigating Long-Term Short Pairing Strategies for LETFs²

In contrast, Khadivar et al. use machine learning techniques to re-evaluate these strategies and find that the “dual short” approach fails to deliver significant positive returns compared to the broader market. Instead, their models indicate that shorting only the bear LETF is the optimal play, particularly when executed after periods of high market volatility. This directly contradicts the market-neutral premise of the first paper, advocating for a directional bias over a pure volatility harvest.

Pitfalls but Improvement with Tests

These opposing conclusions present a problem, but also suggest improvements based on the strategy in our last post. One source claims shorting both sides (bear and bull LETFs) is optimal, while the other argues it is inefficient and that shorting the bear alone is the winner. To resolve this, I backtested both strategies with more modern data (2010–2025). We found that while both papers miss critical factors like borrowing costs, interest rate regimes, and Sharpe ratio computation, we can combine their findings to build a strategy that actually works.