LETFs: Optimally Harvesting Decay

[WITH CODE] Harvesting volatility decay systematically with a 2.5+ Sharpe ratio.

Hello!

Welcome back to (likely) the last post in the LETF / volatility decay series. This one caps off the series with a strategy that has a Sharpe ratio of over 2.5 (dirty Sharpe of over 6) and an annualized volatility of under 2%.

Thank you all for the support over the last few posts. This topic may have been the most interesting one yet to investigate, and it makes me glad to see that it interests you all as well.

Let’s get into it. The code has been sent to you via email.

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Finding Optimal Pairs

Last post, we analyzed whether "Dual Shorting" (shorting both bull and bear LETFs) is more effective than shorting a bull LETF against its underlying index.

We then discovered that shorting bear LETFs is suboptimal because they actually receive interest on short exposure, which offsets the volatility decay that we are trying to harvest. Furthermore, we found that major indices like the S&P 500 and Nasdaq 100 have been too "trendy" lately, and that there are likely better pairs for this strategy.

By switching focus to the biotech sector, we demonstrated that higher volatility and lower trend significantly improved the strategy’s Sharpe ratios (both the clean Sharpe that included the risk free rate and the dirty Sharpe).

However, I speculated that there has to be a better pair out there. Something that has higher vol and rate decay than the biotech sector pair. My intuition turned out to be correct.

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Harvesting Additional Rate Decay

While searching for an optimal pair, we need to keep in mind the borrowing cost and AUM of the LETF. If we choose a LETF that is not liquid, it will be suboptimal for the strategy due to a greater borrowing cost and a higher tracking error (how well the LETF tracks the underlying).

I will go over the strategy details below, but I want to first cover how the strategy actually generates returns, and how it has such a low volatility.

Our PnL is comprised of two main factors: LETF decay from the volatility of the underlying and LETF decay from the interest rate cost of gaining the leverage.

We have discussed volatility decay in great detail. However, we have only covered rate decay a few times. In order to fully understand how LETFs suffer from “interest rate decay,” we need to understand how LETFs gain their leveraged exposure to the underlying.

Most equity-based LETFs use Total Return Swaps. In these agreements, the fund pays a counterparty (usually a bank) a fee (typically pegged to a benchmark like SOFR plus a spread) to receive the multiple of the index return. This creates a linear interest rate drag that is relatively easy to model.

However, certain LETFs gain leverage through futures contracts. This is a critical distinction because the cost of leverage in futures markets is not just a flat interest rate. Instead, the cost is embedded in the “roll” and the “basis.” When the futures price is higher than the current spot price, the market is in contango. The LETF must constantly sell cheaper, expiring contracts and buy more expensive ones, creating a structural drag in the fund’s value.

Furthermore, in markets driven by high speculative demand, the implied funding rates within these futures can skyrocket far above the standard Fed Funds rate (these securities also generally have higher volatility, which is great for us!). This “speculative premium” acts as super-charged rate decay. By identifying assets where the cost of leverage is driven by this futures-based friction rather than simple bank swaps, we can harvest a much larger spread.

In the next section, I will reveal the specific high-volatility pairs that utilize this futures-based structure. We will see how a delta-neutral allocation between these “toxic” LETFs and their spot counterparts produces a Sharpe ratio that significantly exceeds our previous benchmarks.

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Optimal LETF Pair for Harvesting Decay

Now, let’s go into the details of the strategy, and how I came across it. Once again, this section of the first post explains the strategy details more thoroughly.