The Curious Case Of Leveraged ETFs: Understanding How Compounding Works

by on August 16, 2013

Exchange-traded products have found their way into countless portfolios, although more and more investors have begun to utilize these instruments for tactical exposure and not just as buy-and-hold “building blocs” in their portfolios. Leveraged ETFs in particular have become a hot topic in the financial community; seasoned investors that use them understand these instruments very well, while others who are less familiar with them have scrutinized and criticized them based on a lack of true understanding. Andy O’Rourke, Managing Director and Chief Marketing Officer at Direxion, recently took time to discuss the most glaring misconceptions about leveraged ETFs, helping to dispel some of the urban legends surrounding this breed of financial instruments [see also Why Everything You've Heard About Leveraged ETFs Is Wrong]. 

ETF Database (ETFdb): Broadly speaking, what are some of the biggest misconceptions out there surrounding leveraged products?

Andy O’Rourke (AO): I do feel that we (the industry, product producers, and advocates) have come a long way since the early phases of the product lifecycle to dispel the primary misconceptions about the products, but we continue to educate to ensure all that discover the products fully understand their proper objectives and use. We do occasionally still see articles and blogs that have a negative disposition regarding the products, which is based primarily in a lack of full understanding of how they work and how they should be properly used, although these mentions are much fewer and farther between than they used to be.

The primary misconception is that the products are inherently flawed because they are not designed to track a multiple (2x, 3x, -1x) of the cumulative return of the benchmark index for periods greater than a day. People, somewhat understandably so, have a tendency to always want to compare the returns of the daily objective leveraged and inverse ETFs to returns of other buy-and-hold products. This isn’t a good practice because their stated objectives are clearly different. The point is that the products are not flawed.  In fact, they are extremely successful in obtaining their daily goal. They’re just not designed to achieve the goal that some investors would ideally like them too (i.e. obtaining 2x and 3x the cumulative return of the benchmark for extended periods). This is part of the reason that we are specific about stating that these are products for those that think (either permanently or temporarily) with a traders mindset. They are not for those who think only with a long-term, buy-and-hold investor mindset.

The other common misconception is that all compounding associate with leveraged and inverse funds is bad. The reality is that compounding will tend to be negative if market volatility is high. Conversely, compounding will tend to be positive (generate returns that are greater than 2x or 3x the returns of the cumulative returns of the index) when markets are trending and volatility is low. It is interesting that there does tend to be a typically large amount of articles published about negative compounding during high volatility markets, but there are virtually none written about positive compounding when markets are trending and the leveraged funds are benefiting.

The next misconception that I will address is that only sophisticated Institutional traders can and should use leveraged and inverse ETFs. It is certainly true that a certain level of sophistication is needed in order to understand and use the products properly, but a fancy institutional job title is not required. There are plenty of self-directed traders that fully understand how the products work and trade them with a high degree of proficiency [see also How To Be A Better Bear: Short Selling vs. Inverse ETFs?].

Finally, the last misconception that I will address is that leveraged and inverse ETFs should only be held for a single day. It simply isn’t true. While it is true that the funds seek a daily goal, it is more than appropriate that a trader can wish to seek multiple consecutive daily results over longer periods of time. There is no certain stated period of time that one should hold the funds. We very loudly and regularly state that all traders that use the funds should monitor them on a very frequent basis, but as long as they still have conviction about the future directional movement of the benchmark, and they are still comfortable with the amount of risk they are exposed to, they can chose to hold the funds for periods of several day, weeks or even months in some cases. Many traders have been very successful implementing rebalancing strategies that allow them decrease their exposure (and risk) after they have obtain a certain amount of positive returns, or add to their positions after a loss to keep pace with their goals.

 ETFdb: Can you explain how compounding works?

AO: I can, but I think our educational materials do an even better job. Here is a list and links to some of our materials that address the topic of compounding:

Understanding Leveraged Exchange Traded Funds – Pages 6 and 7 specifically talk about compounding

Understanding the Impact of Changing Market Exposure on Leveraged ETFs – A two paged crash course on compounding with leveraged ETFs

Exchange Traded Funds, An example of Daily Investment Results  - A look at four actual days in the life of two Direxion Shares and how compounding impacted their returns during the period

ETFdb: Can traders actually benefit from compounding in certain environments? How so?

AO: As I mentioned earlier, there are scenarios when compounding can be beneficial for leveraged and inverse funds – typically when volatility is low. Our paper entitled Volatility Matters  illustrates the impact of compounding on a pair of Direxion Funds. We show two scenarios:

1) negative compounding when volatility is relatively high

2) positive compounding when compounding is relatively low

It’s interesting to note that the benefits of favorable compounding work for both the bull and the bear funds. In the low volatility scenario, the bear fund lost money, but it lost less money than it would have if it were not reset to a 3x leverage point every day to seek its daily goal.

We think if more people understood the potential earning opportunity that leveraged funds offer during periods of low volatility (assuming the trader gets the direction right), they would be very interested in learning how to use them responsibly.

The Bottom Line: As with any financial instrument, with more sophistication comes more complexity; leveraged ETFs are no exception here, and as such, those that take the time to understand how they work and the risks and nuances involved can successfully utilize these powerful tools in their trading arsenal.

Follow me on Twitter @SBojinov

[For more ETF analysis, make sure to sign up for our free ETF newsletter]

Disclosure: No positions at time of writing.