Everyone loves to hate leveraged ETFs.
There are legitimate concerns when it comes to leveraged ETFs. The first is daily compounding. The second one is market timing. The final one is just plain old getting your punt wrong. In a three part series, I will show you that while all three are valid concerns, they are no reason to stay away from leveraged ETFs.
Part 1 deals with daily compounding.
As all investors know, compounding is good. It builds wealth faster. We all know this from our finance classes in school, that simple interest calculation yields worse than compound interest calculation. Also, daily compounding is better than weekly, and weekly better than monthly. However, when it comes to leveraged ETFs, the general perception is that compounding is the worst thing since the Black Plague.
This is how it works. Let's say you have an instrument A that goes up 1% one day, and down 0.99% the next day. Let's say you have another instrument B that is 3x leveraged on A. This one will be up 3% the first day, and down 2.97% the second day.
So far, so good. From this evidence, you may believe that both A and B should be slightly up, or no worse than flat. Not so, my dear Watson.
At the end of the two days, A will be flat, while B will be slightly down, by about 0.1%. That's the challenge of compounding. When the average trend is flat but there is volatility, the more you leverage the more you lose. For example, if you leveraged B 10x against A, B would have been down some 0.9%.
So, say no to leveraged ETFs? That's the general sentiment. It is also wrong.
Leveraged ETFs are no different than any other leveraged instruments. You can leverage the core ETF on your own by having a margin account. You can buy puts or calls on the underlying ETF. You can trade futures on the underlying index. All of this creates leverage, and with it comes the same behavior as you see in the case of leveraged ETFs. It is just that the leverage is done for you, for a fee, when you buy a leveraged ETF.
So, is leverage bad? Thing is, people leverage every day. When you take a mortgage, what you are doing is creating leverage for your money. When house prices go up, you have spectacular ROI on your down payment. When they go down, well, we all know what happens when they go down. (Can someone spell foreclosure?)
Leverage is the core of the modern financial system. In general, it creates value. It also has the potential to destroy value - and lots and lots of it. We all know that from the financial crisis, but a better example is Long Term Capital Management. It used large amounts of leverage to boost gains. The returns were spectacular, till they were not.
The above shows the value of $1,000 invested in LTCM, the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.
In other words, the problem is not one of daily compounding. The problem is one of volatility. Volatility increases risk. Leverage increases volatility and hence increases risk even more. That is the core issue. If you are not comfortable with leverage, don't buy leveraged ETFs. But if you are, don't shy away from leveraged ETFs because of the specter of daily compounding. That's a non-issue.
Now, let's examine the facts, shall we? Since the future belongs to China (so I am told), let's examine three China ETFs, FXI (based on the benchmark FTSE China index), YINN (3x leveraged on another China index), and ProShares Ultra FTSE China 25 ETF (NYSEARCA:XPP), which is 2x leverage on the same underlying index as FXI. This is how the three have performed over the last year (with lots of daily compounding, to aid in our case study).
FXI is up 4.2%. In other words, the trend is more or less flat, with lots of volatility, the exact scenario that the leveraged ETF naysayer would like to point out as the perfect storm. And they are more or less.. wrong.
XPP, which is 2x leveraged on the same underlying index as FXI, is up 10.7%. In other words, 2x leverage gave a 2.5x excess return. This is how leverage works, just as daily compounding can crush you, it can help you as well. To rule leveraged ETFs out because of volatility and the impact of that on daily compounding makes absolutely no sense.
YINN, however, is down - are you ready for this? - 23.3%. I have seen articles blaming daily compounding for that. While I will explain why that argument makes no sense whatsoever, I would like to leave you, dear reader, with a homework problem.
Why do you think YINN is down so much when both FXI and XPP are up?
To be continued ...
Disclosure: I am long FXI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.