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Understanding Leveraged ETFs

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Unquestionably, leveraged ETFs are the most misunderstood product in the exchange-traded world today. These tools have been subject to government scrutiny, lawsuits, and general confusion from the investing public over how these products work and why they can produce returns that can leave some investors scratching their heads. In fact, leveraged ETFs have taken the blame for everything from the Flash Crash to the general increase in market volatility despite the fact that these funds make up a tiny part of the overall ETP world.

The main misconception regarding these specialized ETFs—and why some investors are skeptical of their value-- stems from their daily rebalancing feature. Take for example this hypothetical case courtesy of Direxion, a leading provider of leveraged ETFs:

As you can see in the chart above, although the index did not move in aggregate over the period, the 3x leveraged ETF lost about 4.5%. This is entirely due to the daily resetting feature of the ETF which means that exposure to a particular index resets at the end of every trading day. These ETFs are designed to give triple (or double in some cases) exposure over a single trading day and not any time period greater or less than this amount.

As a result of this, any investor that buys into a fund in the middle of a trading day and sells out by the end or one that holds onto a security for multiple trading periods, is likely to have a trading experience that is different from what the creators of the product designed for the fund. This suggests that performance over a long time period when investing in a leveraged ETF can often deviate from what investors might otherwise be expecting, potentially producing inferior returns (see ETFs vs. Mutual Funds).

With that being said, it does not mean that the product is inherently flawed or destined to lose money. For example, take into consideration the following two scenarios which show that a leveraged ETF is not built to underperform. The first one, once again courtesy of Direxion, shows what happened in a 3x leveraged ETF when the market is steadily adding to its gains:

As you can see, the fund actually outperforms the ‘expected’ return by close to 15% in the time frame in question. Yet, this situation isn’t exclusive to surging markets as a similar situation can take place in a bearish trend. The next chart explores what happens with a 3x leveraged ETF in a rapidly declining market:

As you can see, a 3x leveraged ETF would outperform the ‘expected’ return during a slumping market by a pretty wide margin. So in other words, market trends that go in one direction over a few trading periods are likely to help leveraged ETF investors while an oscillating market, that goes between gains and losses, can lead to decay for those holdings these products (read Alternative ETF Weighting Methodologies 101).

In summary, the issue of leveraged ETFs almost entirely stems from compounding and the impact of this phenomenon over multiple periods. In essence, the index never rebalances in the examples above but the 3x leveraged fund does, and on a daily basis no less. The triple leverage comes into play each day on the value of the index; think of it as though the product buys into the market and sells out at the end of each day. This trading takes place each time the market is open, making returns over multiple periods wholly different than those of a similar index that does not rebalance in the time frame.

This issue of compounding, if you are still having trouble with the concept, is analogous to how a savings account compounded quarterly, as opposed to daily, will produce different rates of return. Yet just because the returns are different, however, doesn’t mean that the funds should be banned or blamed for all of the ills in the marketplace. Instead, investors just need to be very aware of the structural features of this product class and how this can impact bottom line returns, especially over multiple trading periods (see ETFs vs. ETNs: What's The Difference?).

Overall, leveraged ETFs are powerful tools and should probably not be used by long-term buy and hold investors, thanks to some of the issues outlined above. Yet for those seeking to hedge exposure or make a short-term bet on the direction of the market or a particular sector, these funds can make for welcomed additions to a portfolio. Just remember that leveraged ETFs can often deviate from what investors may be expecting over a long time horizon and that whenever you deal with leverage, the position must be monitored closely.

For more on this subject see Direxion’s PDF on the topic here.

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