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Daily Rebalancing: How Leveraged ETF Exposure Works


Leveraged ETFs are more complicated than the standard ETF, especially when it comes to calculations of daily rebalancing.


Leveraged ETFs are more complicated than the standard ETF, especially when it comes to calculations of daily rebalancing.

Due to the leverage attribute itself – in which ETFs change 2x or 3x the underlying basket of securities – a large portion of traders in leveraged ETFs keep their positions open one session or less. In this regard, leveraged ETFs are a type of day trader's mutual fund. However, for those traders with a more expanded perspective, keeping positions open longer may also produce a compounded benefit – or cost. The risks of leveraged ETFs are far higher than those for the 1-to-1 variety. For many, the leverage equals greater and faster profits, but it can also mean greater and faster losses.

Because the leverage represents a daily calculation of movement in the index it tracks, the calculation takes place daily. By holding shares of a leveraged ETF over many sessions, the compounded result may be different than the daily calculated 2x or 3x of the index.

In other words, by keeping shares beyond a single session, traders double down or triple down on the calculation. This means profit and risk potential change exponentially. The volatility of the index is reflected in the leveraged change in value of the ETF shares. In a 3x fund, for example, every $100 of initial shares bought will grow by 3x, not on the initial investment but on each day's rebalanced value. So over five days, what happens to that $100 in a 3x fund?

In trending markets with low volatility, the performance for periods longer than a day may exceed the return of the index, multiplied by the beta of the portfolio, as demonstrated in the first two scenarios below.

Market Rises Steadily
In a steadily rising market, the fund's gains may be larger than expected. In this first example, the ETF gained 89.85%, more than the 75%gain expected, given the 25%index gain and the fund's beta of 3.

Market Declines Steadily
In a steadily declining market, the fund's loss may be less than expected. In this next example, the ETF declined 60%, less than the 75% loss expected, taking into consideration the 25%index loss and the fund's beta of 3.

In volatile markets, the pursuit of daily investment targets will have a negative impact on the ETF's performance for periods longer than a single day, as illustrated in this final example.

Market Is Flat, Yet Volatile
In this last example, the index is flat for the six-day period, but the fund lost 4.50%, despite achieving its daily target.

Essentially, leveraged ETFs are likely to underperform in volatile markets as a result of the need for constant, substantial portfolio adjustments. Users of leveraged ETFs are encouraged to monitor the changing exposure provided by their investment and modify share holdings as they deem necessary.

At this moment, the 3x held for five days actually rose by 4.4 times rather than just by 3. However, the position is still vulnerable. If values were to fall as dramatically, even a net profit position would be likely to perform under the 3x based on recalculation at a higher starting point than original investment value. It may even be possible due to daily rebalancing for the leveraged ETF to produce a negative yield even when the underlying index had moved higher over a period of sessions.

With this potential problem in mind, leveraged ETFs may not be appropriate as part of a buy and hold strategy (or, as it has been termed, a "buy and forget" approach). Some traders will increase or decrease holdings based on how they believe the index will perform in coming sessions. However, fees and expenses will erode profits if this is used excessively.

The problem applies equally to a short-moving ETF, in which the value of the holdings move in opposite direction to the underlying index. The rebalancing accelerates the potential loss levels in the same degree as it accelerates profits, a key point to keep in mind any time leverage is in play.

Twitter: @MichaelThomsett

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