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 of this series dealt with market timing, when I showed that for market timing to hurt leveraged ETFs, one of a pair of matched bull-bear ETFs would have to gain at the expense of the other, and there is no evidence of that.
Part 3 deals with getting your punt wrong.
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, the BNY Mellon China Select ADR Index (BKTCN).
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%). YINN, however, is down 18.6%. Having debunked the myth that daily compounding nor market timing can be responsible for this disconnect between FXI, XPP and YINN, we are left with only one possibility. As Sherlock Holmes would say:
When you have eliminated the impossible, whatever remains, however improbable, must be the truth.
Folks investing in YINN simply got their punt wrong. The stocks comprising the index upon which YINN is built is different from the stocks that comprise the index upon which XPP is built. In other words, you simply can't compare the performance between FXI/XPP and YINN.
Over the past year the China Select ADR Index has been down 2.4%. As YINN is 3x leveraged on this index, YINN should have been down 7.2%. However, YINN is down 18.6%, and this is again where volatility comes into play. When the overall trend is up, volatility will amplify the leveraged return, as it did for XPP. When the trend is down, 3x leveraged ETFs like YINN will get clobbered, and more than they should have been strictly in terms of leverage.
So, what is the morale of the story? Well, it ultimately comes down to stock picking. If you pick the right underlying, you will be rewarded handsomely should you choose to leverage (and are comfortable with the volatility). However, if your punt goes south, you will get clobbered. Getting your punt right is the key issue. It is not an issue of market timing or daily compounding at all, despite articles to the contrary including the venerable Wall Street Journal.
One mystery remains, however. If BKTCN is down, why isn't YANG, 3x leveraged short on BKTCN, up handsomely? I am doing a set of simulations to explore why. Let me note that it is not an isolated issue of YINN/YANG. The same issue exists in other paired ETFs like [[NUGT]]/DUST, and I believe that a synthetic that shorts both the long and the short 3x leveraged ETFs in tandem is (almost) risk free money. However, this doesn't hold for all ETF pairs, and I am doing more research to identify the characteristics of pairs where this behavior is likely to exist.
More on that coming in a later series of articles.
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.