I’ve come across many market participants believing if they purchase a leveraged ETF and held it for an extended period of time, the ETF’s performance should double the index or sector it’s benchmarked against.
Please understand this is not the case. The majority seek to provide a 200% DAILY return on the underlying index they track.
Notice I typed “DAILY”!
Noted in the ETF providers prospectus, which I’m sure we all read quite diligently. It is stated the leveraged ETF is designed to double the Daily return, not the total return for time periods greater that one day.
I noticed this while I was helping a hedge fund that trades ETFs quite heavily. The were using the leveraged ETFs to hedge the portfolio and noticed the hedge was not delta neutral. The hedge was actually appreciating more than what the underlying portfolio was depreciating.
So, why does this happen? Why doesn’t it track properly if market participants hold positions overnight? Compounding! Just as we all like compound interest you get the same effect here, except since the ETF can depreciate in price it can work adversely too.
Over time the effect of compounding and leverage can have a significant effect on the total return of the ETF.
Here is an example assuming a $10,000 investment.
Day 1:
The underlying index increases 1%
The leveraged ETF increases 2%
The first day = 200% return, just as we thought, and we outpaced the market, great!
Day 2:
The underlying index decreases 1%
The leveraged ETF decreases 2%
Underlying Index Value: $9,999 (An increase of $100 and then a decrease of $101 on day two)
Leveraged ETF Value: $9,996 (an increase of $200 and then a decrease of $204)
As you can see the index decreased in value $1 over two days and the leveraged ETF decreased $4 over the two days (this is four times the cumulative index loss as opposed to two times the loss).
Hopefully, I’ve explained this in detail enough for you to see how over a longer period of time the cumulative percentage change of the leveraged ETF has the ability to vary significantly from the underlying index.
Here are a few popular Leveraged ETFs:
If you would like to learn more about leveraged ETFs visit my home page http://etfupdater.com or http://proshares.com.
Mike Matousek, CMT
Portfolio Manager, ETF Updater
http://etfupdater.com
ETF Swing Trading and Day Trading 