In this part of my series, I will make an introduction to the leveraged ETFs and explain how the “tracking-error” or if you want compounding works with those instruments.
The leveraged ETFs are designed in the way that their daily % yield or loss is multiplied compare to the non-leveraged instrument. At first glance, this may sound very attractive for investors – the potential returns compare to the classic non-leveraged instrument might be very interesting – but as you can guess, each coin also has its other side.
Let us now analyze in more details the situation that can occur on the market to see the impact of these circumstances on the price of non-leveraged and leveraged ETFs – for example, consider ETN: VXX (was already discussed earlier) and its 2x leveraged version ETF: UVXY.
- Continuous growth
Imagine, for example, that VXX will grow by 5% a day for 2 days, so, UVXY will be increased by 10% for each of these days with respect to its 2x leverage. For simplicity and better understanding, the value of both instruments at the beginning of the monitored period is 100.
VXX will, therefore, be at 110.25, with an increase of 10.25%. UVXY will grow to 121, which means a 21% increase.
It can be said that in such a scenario, the leveraged ETF overcomes the leverage since 21 / 10.25 = ca. 2.05.
- Continuous decline
Now we are looking at the opposite situation, ie a steady decline in the market.
Let’s say VXX will decrease by 5% a day for last two days, while UVXY logically drops by 10% and then by another 10%. Let’s consider the same price of 100 at the beginning, ie VXX will decrease by 9.75% to 90.25 after those two days, while UVXY will drop “only” by 19% to 81.
Thus, in this case, the leverage weakens less than the specified multiplier 2, namely, it was “only” about 1.95x.
- Volatile period, and the problem of long-term possession
Finally, let’s take a look at the last example when the market is going through a more volatile period, so the VXX will grow by 5% on the first day, while the next day will fall by 5%. 2x leveraged ETF: UVXY will go up 10% the first day, while the next day will drop 10% down.
If we start again on the day 1 at 100, VXX will end on the second day at 99.75 (down 0.25%), while UVXY will fall to 99 (a 1% drop).
Thus, UVXY recorded a 4 times higher loss than non-leveraged VXX.
From this scenario – the volatile and non-trending market – it is also obvious that the leveraged instrument is losing even though the non- leveraged instrument remains virtually the same.
This is a very important conclusion that we can demonstrate on the following scheme.
If the underlying asset rises from 100 to 125 on the first day, and on the second day this asset falls back to 100, then the leveraged ETF instrument first rises to 150 on the first day and drops to 90 on the second day.
So, if we are shorting the leveraged instrument – we speculate on its decline – we do not need again a change in the underlying asset price to generate 10% alpha in 2 days, which sounds very interesting.
On the next chart, I will show the impact of leverage and volatility on ETF disintegration. So, if we use the same example for a 3x leveraged ETF, then that difference, that tracking error, will not be 10%, but 30%.
It is therefore clear that, under given circumstances, these leveraged ETFs are by no means suitable for long-term possession. On the contrary, they represent ideal candidates for long-term short positions. Even here, however, be cautious and avoid unnecessary mistakes. We will talk about it further in next part of my series.