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Leveraged ETFs

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Leveraged ETFs have received tremendous media attention and are proving to be extremely popular with both individual and institutional investors. There are hundreds leveraged ETFs, covering virtually every asset class and industry sector. The majority is double-leveraged, but there’s a sizeable group of triple-leveraged ETFs.

For professional investors, leveraged ETFs are useful in statistical arbitrage, short-term tactical strategies, and for use as short-term hedges without the need to roll futures. For individual investors, leveraged ETFs are alluring because of the potential for higher returns.

What Does Leverage Mean

Uninformed investors might assume that the leverage returns are generated on continuous basis, so that if an underlying index is up 5% for a month, the double-leveraged ETF will be up 10% for the same month; if the index is up 10% for six months, the ETF will be up 20%, and so forth. That is absolutely not the case. The leverage is determined on a daily basis and the returns for any other period usually will not be double or triple the underlying index.

In order for the leveraged funds to achieve appropriate levels of assets so they can provide their implied leverage, they have to rebalance daily. In the case of an ETF providing long two-times leveraged exposure, they would typically attain exposure to a notional set of assets equal to two times their NAV. An example would be an ETF that takes in 100 units in assets that does a swap with a counterparty to provide exposure to 200 units in performing assets. The rebalancing activity of these funds will almost always be in the same direction as the market.

In essence, a leveraged ETF is essentially marked to market every night. It starts with a clean slate the next day, almost as if the previous day had not existed. This process produces daily leverage results. However, over time, the compounding of this reset can potentially vary the performance of the fund versus its underlying benchmark. This can result in either greater or lesser degrees of final leverage over individual holding periods.


Generally speaking, daily compounding of leveraged long ETFs can result in increasing percentage gains in rising markets and decreasing percentage drops as markets trend lower. If an index rises for several days in a row, the trending movement is very important, as that will translate into ETF growth at a faster pace as the value of the index is increasing. For a long leveraged product, it will outperform its expected goals in a rising market and will underperform its expected goals in a falling market.

In Exhibit 1 we see what happens to value of a double-leveraged ETF in a market that rises 10% each day for 10 days in a row. The index and the double-leveraged ETF tracking that index both started out at 100. As the market rose 10% on day 1, the index also rose 10% to 110, and the ETF rose two times 10% to 120. In essence, the ETF is doing what it is supposed to do: produce results that equal two times the daily performance of the index. However, because of an increasing price, those gains are driving the value higher at a faster pace. What this shows is that in a trending market - because of daily compounding - you achieved a return of much greater than twice the index return.

Exhibit 1: Rising Market Data Grid—Market up 10% Daily for 10 Days

Days Elapsed Daily Market Performance Expected Index Level Expected 2x Leveraged Long ETF Level Daily ETF Performance
0 0.00% 100.00  100.00   
1 10.00% 110.00  120.00  20.00%
2 10.00% 121.00  144.00  20.00%
3 10.00% 133.10  172.80  20.00%
4 10.00% 146.41  207.36  20.00%
5 10.00% 161.05  248.83  20.00%
6 10.00% 177.16  298.60  20.00%
7 10.00% 194.87  358.32  20.00%
8 10.00% 214.36  429.98  20.00%
9 10.00% 235.79  515.98  20.00%
10 10.00% 259.37  619.17  20.00%
10-Day Cumulative Change 159% 519%    

In Exhibit 2, you can see the grid depicting the opposite event. In this situation the market drops 10% per day for 10 days straight. In this example, as the index drops from 100 to 90, producing a 10% move of 10 points, on day 2 the down move will be 10% and only 9 points. The daily compounding of the leveraged ETFs will magnify this effect. While the ETF will be achieving a negative 20% move on a daily basis over the longer-term horizon, the compounding will result in a much less significant move downward than two times the index drop. In this example, with the index down 65% over the 10-day period, the ETF is down only 89% (rather than 130%) percent because it was losing progressively less in notional points every day.

Exhibit 2 Falling Market Data Grid—Market Down 10% Daily for 10 Days

Days Elapsed Daily Market Performance Expected Index Level Expected 2x Leveraged Long ETF Level Daily ETF Performance
0 0.00% 100.00 100.00   
1 –10.00% 90.00 80.00 –20.00%
2 –10.00% 81.00 64.00 –20.00%
3 –10.00% 72.90 51.20 –20.00%
4 –10.00% 65.61 40.96 –20.00%
5 –10.00% 59.05 32.77 –20.00%
6 –10.00% 53.14 26.21  –20.00%
7 –10.00% 47.83 20.97 –20.00%
8 –10.00% 43.05 16.78 –20.00%
9 –10.00% 38.74 13.42 –20.00%
10 –10.00% 34.87 10.74 –20.00%
10-Day Cumulative Change –65% –89%    

Finally, in Exhibit 3, you can see the results from a market that is range bound, although in a high volatility drift. The market is up 10% and down 10% alternatively for 10 days straight. This gut-wrenching movement would exacerbate the drag on a leveraged long ETF position. Although the movements are of equal size daily and the ETF is still achieving its daily two times return goal, it endures significant drag on its long-term performance.

Exhibit 3: Flat and Volatile Grid—Market Up 10% and Then Down 10% for 10 Days

Days Elapsed Daily Market Performance Expected Index Level Expected 2x Leveraged Long ETF Level Daily ETF Performance
0 0.00% 100.00 100.00   
1 10.00% 110.00 120.00 20.00%
2 –10.00% 99.00 96.00 –20.00%
3 10.00% 108.90 115.20 20.00%
4 –10.00% 98.01 92.16 –20.00%
5 10.00% 107.81 110.59 20.00%
6 –10.00% 97.03 88.47 –20.00%
7 10.00% 106.73 106.17 20.00%
8 –10.00% 96.06 84.93 –20.00%
9 10.00% 105.67 101.92 20.00%
10 –10.00% 95.10 81.54 –20.00%
10-Day Cumulative Change –4.90% –18.46%    

These are the types of results that you can expect to receive if you hold a leveraged ETF position for more than a day. They demonstrate how there is a path-dependent function of leveraged ETF returns that will have a direct effect on their long-term return results. If your timing and positioning are correct, then this effect can be a benefit to your positioning, and if it's not, they can be a drag on your portfolio. So it’s important that you are correct on your market direction and your timing. You will need both to be correct to help position you when trends begin.

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Article copyright 2011 by David J. Abner. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange-Traded Funds with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
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