There are three common concerns when it comes to leveraged ETFs, prompting many commentators to shun them completely. The first is daily compounding. The second one is market timing. The final one is just plain old getting your punt wrong. While all three are valid concerns, I believe that they are no reason to stay away from leveraged ETFs.
Part 1 of this series dealt with daily compounding, when I showed that daily compounding doesn't hurt returns for leveraged ETFs even when the underlying is more or less flat, and there is plenty of volatility.
Part 2 deals with market timing.
For case study purpose, I considered three China ETFs, the iShares FTSE China 25 Index ETF (NYSEARCA:FXI), the ProShares Ultra FTSE China 25 ETF (NYSEARCA:XPP), which is 2x leverage on the same underlying index as FXI, and the Direxion Daily China Bull 3x Shares ETF (NYSEARCA:YINN) which is 3x leveraged on another China index.
Over the last year, FXI is up 7.2%, and XPP, 2x leveraged on FXI is nicely up 17.2%, more than one would have expected it to rise (i.e., 14.4%). This debunks the myth that daily compounding hurts leveraged ETFs.
YINN, however, is down 18.6%. How could this be, many commentators ask. The common blame is on market timing and daily compounding. Having debunked the daily compounding myth, let us examine if market timing is behind the fall of YINN.
This is how market timing works. Since leveraged ETFs have to rebalance the portfolio every day, they are signaling ahead of time what their intentions are. Hence market makers can influence the direction of the underlying and front run the orders, thus providing disadvantaged prices. This is a good theory, and I am sure this happens in practice. However, this misses the flip side of the equation.
Many leveraged ETFs come in pairs. There is a bull index, that leverages 3x buys, and there is a bear index that leverages 3x shorts. The underlying is the same in both cases. Hence, if market makers were to front run the underlying in one direction, they would end up benefiting the other direction. Since the rebalancing ostensibly happens at the same time for both the bull and bear leveraged ETFs, if one of the pair gets harmed by market timing, the other pair has to benefit.
So, how has the counterpart of YINN, the Direxion Daily China Bear 3x Shares ETF (NYSEARCA:YANG), done over the past year? Curiously, it is down 25.4%. So now the yin-yang balance is completely off, and both the bull and the bear ETFs are down. With that goes the myth of market timing pushing YINN down, as then YANG should have benefited.
The plot thickens, dear reader. Not only we have YINN down when FXI is up, the counterpart, YANG, is down as well. So, how can this be?
To be continued ...
Disclosure: I am long FXI, XPP. 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.