Quizmaster Doug Hutchinson has come up with another great quiz that explores the compounding effect of leveraged ETFs. Let’s see what the math has to say.
Good luck!
Consider this Scenario:
Your friend Brian purchased $1,000 of an Exchange-Traded Fund (ETF) that aims to track Index Y. He also purchased $1,000 of a leveraged ETF that aims to deliver 2x the daily return of Index Y (for example, if Index Y goes up by 1% on a certain day, the leveraged ETF should go up 2% on that same day).
The daily returns for the ETF that tracks Index Y were:
Day 1: -10%
Day 2: 11%
Day 3: -10%
Day 4: 13%
While many factors cause leveraged ETFs to not return in multiples of the non-leveraged fund tracking the same index, for the purpose of this example, let’s assume the daily returns for the leveraged ETF were exactly 2 times the daily return of the unleveraged index for each of the 4 days.
At the end of Day 4, Brian notices that the value of his position in the unleveraged ETF has gone up by a total of 1.598% and his position is now worth $1,015.98.
Brian is very happy because he assumes the return on his leveraged ETF is exactly twice the return of his unleveraged ETF (2 x 1.598% = 3.196%) and his position in the leveraged ETF will now be worth $1,031.96 ($1,000 x 1.03196 = $1,031.96). Brian is very surprised to learn that the value of his leveraged ETF actually declined and is now only worth $938.80.
Why was Brian incorrect to assume that the return on his leveraged ETF would be exactly twice the return on his unleveraged ETF?
*For the purpose of this example, ignore all costs such as trading commissions, ETF expense ratios, custody fees, etc.
Answer:
The leveraged ETF delivered exactly twice the return of the unleveraged ETF on that day only. Investment returns for periods that are longer than one day are effected by compounding. The compounding effect increases with higher volatility, greater leverage, and longer holding periods.
Here are the day-to-day returns for Brian's leveraged ETF position. The return for each particular day is exactly twice the return of the unleveraged ETF for that day.
Start of Day 1: $1,000 x (1 - 0.20) = $800 end of Day 1 value
Start of Day 2: $800 x (1 + 0.22) = $976 end of Day 2 value
Start of Day 3: $976 x (1 - 0.20) = $780.80 end of Day 3 value
Start of Day 4: $780.80 x (1 + 0.26) = $983.81 end of Day 4 value
Leveraged ETFs aim to deliver a multiple of a return on an index on a daily basis. As your friend Brian discovered, if your holding period on a leveraged ETF is longer than one day, the return for the holding period may be much different than the investor anticipated.
Check out another quiz from Doug's Quiz Corner!
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy. Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange-Traded Fund (ETF) carefully before investing. Leveraged and Inverse ETFs may not be suitable for all investors and may increase exposure to volatility through the use of leverage, short sales of securities, derivatives and other complex investment strategies. These funds' performance will likely be significantly different than their benchmark over periods of more than one day, and their performance over time may in fact trend opposite of their benchmark. Investors should monitor these holdings, consistent with their strategies, as frequently as daily. A prospectus contains this and other information about the ETF and should be obtained from the issuer. The prospectus should be read carefully before investing.
