Understanding Triple Leveraged ETFs

Much has been written about the math behind leveraged ETFs and mutual funds, yet most investors fail to realize the true impact. As a result, many of these products have been ridiculed for failing to meet user expectations.

Contrary to popular belief, leveraged and inverse products that reset their exposure level every day are not new. Rydex introduced the concept with the launch of Rydex Nova (RYNVX) in 1993 and Rydex Ursa (RYURX) in 1994 (note: Ursa has since been renamed Rydex Inverse S&P 500 Strategy).

However, as more and more leverage is applied in these products, the adverse impacts appear to grow exponentially. Direxion introduced 3x ETFs in late 2008, and now we have five months of data to look at.

For this example, I have chosen two inversely related leveraged funds: Direxion Financial Bull 3x Shares (FAS) and Direxion Financial Bear 3x Shares (FAZ). The chart below illustrates the returns for the five-month period from 11/6/2008 through 4/6/2009 for the following four scenarios:

1. Green Line: Buy and hold FAS = -86.3%
2. Red Line: Buy and hold FAZ = -76.9%
3. Yellow Line: Buy and hold equal amounts of FAS and FAZ with no rebalancing (what some might consider a perfect hedge) = -81.6%
4. Cyan Line: Buy equal amounts of FAS and FAZ and rebalance every day (a lot of work) = -25.0% (not counting transaction fees and slippage)

click to enlarge

Chart and data by www.FastTrack.net

Even if you go to the trouble of rebalancing every single day the market is open, you are still fighting a headwind of 25% for a five-month period. Most people would consider that impossible to overcome on any kind of continuing basis.

I’ve said it before and I’ll say it again: Leveraged ETFs can be great short-term trading instruments, but make sure you understand the longer-term impact before holding any of them for more than a few days.

All the ETF sponsors of leveraged and inverse products provide warnings and educational material. Here are links to such information for DirexionShares, ProShares, and RydexShares.

Disclosure: no positions

Comments

[E Thomas St.:]

Some of this performance stuff isn't even as complicated as one has to make it. The performance of two ETFs tracking the same index in opposite directions is not scaled linearly. You can do simple multiplication to figure this out (A large downside move needs an even large upside move to offset it. A 10% drop needs more than 10% upside to get back to the initial value the next day. A 10% gain can be lost by 10% loss the next day. Now do this again and again and again.) It doesn't matter much if there is leverage involved, but it does exacerbate the propensity to lose money. I've also noticed that for a traded pair to stop losing money there needs to be a 3 day trend one way or another. Even so, a 4 day trend of equal gain every day one way can be wiped out by a 2 day trend the other way.

The only ways you ever come out ahead on traded pairs is when one part of the pair goes above 100% (offsetting the possible zero value of the down side wholly. Look at DTO/DXO for this) , when you time the purchase correctly (which is kind of defeating the purpose of the supposed strategy of being market neutral), or when there is a strong trending period (which brings into question why you didn't put all of it on the ETF that was trending).

Apr 10 12:56 PM

[E Thomas St.:]

One final way to come out ahead is you trade the pair on the thesis of mean reversion where you have purchase the pair at the mean (if you can really determine that for some of these products) and you sell the one that goes up at some point in the future, then wait for the value to return to mean. I don't buy this hypothesis working in reality but it is still a possible way to use them.

Apr 10 01:06 PM

[moneynevers...:]

Great products that tend to get a lot of bad press. I really wish Cramer would lay off on his criticism of these products as they are great tools when used correctly.

moneyneversleepsblog.b...

Apr 10 03:19 PM

[bsharvy:]

That makes absolutely no sense. They are rebalanced every day, therefore, the leverage is 3x every day. Your leverage after holding them a while can't be any different from someone who just bought them. The shares are identical.

On Apr 08 01:22 PM Ron Rowland wrote:

> The reason these things work this way is because the daily reset
> of the leverage results in higher "effective" leverage every day
> the trend continues to move in your direction.
>
> For example, say you buy a 3x fund that moves in your direction for
> a few weeks and you are now sitting on a 100% gain. At that time
> your leverage is about 6x from where you started. And most importantly,
> it is at 6x at the worst possible time - when the trend reverses.
> So now you have 6x leverage working against you.

Apr 10 07:17 PM

[jt77:]

(This is taken from a post by Franjime on the MarketTicker blog)

"Thought experiment:

Over the weekend, the Fed announces the discovery of a Skittle-defecating unicorn.

Bank stocks rally so much on the news that on Monday, the index that FAS/FAZ is based on (Russell 1000 Financial Services Index, I believe) goes up 34%. FAZ goes to $0.01. FAS triples from $8.50 to $25.50

Monday evening, the Fed announces that the Skittle unicorn died due to a massive Ex-Lax overdose.

The next day, the index plummets 34%. FAS goes from $25.50 to $0.01. FAZ rallies to $0.03."

Clearest example I have seen yet.

Apr 11 10:10 AM

[Ron Rowland:]

bsharvy says: "That makes absolutely no sense. They are rebalanced every day, therefore, the leverage is 3x every day. Your leverage after holding them a while can't be any different from someone who just bought them. The shares are identical."

I will try to explain once again. If you buy for $1 with 3x leverage, you are now controlling $3. If the underlying index goes up ~33%, then your $1 investment is now worth $2 due to the 3x leverage. You are also now controlling $6 worth of the underlying. Therefore, your original $1 investment is now effectively leveraged 6x.

Someon who "just buys in" has to pay $2 to match what you now have. They are leveraged 3x, but since you only paid $1, you are now leveraged 6x.

With daily reset of leverage, your "effective" leverage changes every day.

jt77 is correct. A 33% move is a total wipeout for one of the pair. If the 33% move reverses the next day, then the surviving member of the pair is wiped out too.

That is why there will never be a 4x equity ETF - because then it only takes a 25% move for a wipeout. See prediciton #5 in
investwithanedge.com/f...

Apr 11 01:40 PM

[optionsgirl:]

Ron Rowland, your writings are thoughtful, your explanations are easy to understand, and I really appreciate your analysis. Thank you for sharing.

Apr 11 02:44 PM

[Reader851:]

Ron Rowland, your logic is wrong. In your example, the value of your investment has increased from $1 to $2. Thus, your current investment, now $2, is levered at 3x, not 6x. You're ignoring the changing value of your investment when calculating leverage. You're erroneously remaining focused on the original cost of the investment.

The original investment cost is irrelevant, in terms of calculating leverage. That's why brokerages keep changing borrowing power in margined accounts. They base borrowing power -- leverage -- on the current value, not the original value, of the investment. Better try again.

Apr 11 03:08 PM

[Ron Rowland:]

You are correct that my "new" leverage is 3x based on my "new" value of $2. That is how they make it a level playing field for everyone who buys in on different days. They reset the leverage every day so that whatever day you buy you are getting 3x. That is why I was using the term "effective" leverage.

Now look what happens on the next 33.3% increase of the underlying. The underlying now goes from 1.33 to 1.78 (1.33*1.33). The person who bought in at $2 saw his value jump by 100% to $4. My $1 purchase rose by another $2 to $4, which made the profit on my original $1 jump from 100% to 300%. Both are now controlling $12 of the underlying and their investments are valued at $4.

Now let's look at conventional 3x leverage. If I had used "conventional" leverage, I would have used my $1 and borrowed $2 dollars to control $3 of the underlying. After the underlying made two 33% jumps to 1.78, I would now control 1.78*3 or $5.34 of the underlying (that is how conventional 3x leverage works). My investment would be valued at $3.34 after paying back the $2. (Note: this is $3.34 versus $4 if using 3x funds).

Additioanlly, by using a daily reset 3x fund, I would now control $12 of the underlying. $12 versus $5.34. If my $1 purchase is controlling $5.34 using 3x conventional, and is controlling $12 using 3x with daily reset, then it is "effectively" 6x now (okay so maybe I should have said 6.7x)

The point I am trying to make is that the daily reset causes your leverage to compound. It is exponential - look at the "next 33% increase in the underlying - using conventional 3x you are now controlling 3*2.36 or $7.1 of the underlying. Using daily reset 3x leverage you are now controlling $24 of the underlying.

Perhaps my terminology doesn't match your terminology, but I think you will agree that conventional leverage and daily reset leverage are not the same thing over time. They are the same thing for one day and one day only.

Apr 11 04:28 PM

[aarc:]

xETF has price compounding effect that theoretically favors the bulls rather than the bears.

Make a simple straight line computation of the compounding effect of xETF.

I have an example: Starting price of $10 and 10% rally everyday for 5 days.

Day 1 $10.00
Day 2 1xETF = $11 2xETF = $12
Day 3 1xETF = $12.10 2xETF = $14.40
Day 4 1xETF = $13.31 2xETF = $17.28
Day 5 1xETF = $14.64 2xETF = $20.736

Total Profit 1xETF = $4.64 2xETF = $10.73

2xETF performance over 1xETF = 231%.

Do your own calculation to the downside: My calculation yielded a 2xETF 172% yield over 1xETF. Meaning, profit potential to the downside is not as good as the upside with the 2xETF price compounding effect.

Lets look at the XLF and UYG:

During the last downturn and the most recent upturn using peak to trough and trough to peak resply:

XLF went down from 10.09 early Feb to 5.88 early March for a 41.7% percent profit for shorts in 19 trading days. It went up from 5.88 early March to 9.90 mid March for a 40.6% profit for longs in 10 trading days.

UYG using the same 19 days down and 10 days up yielded a profit for shorts of 63.80% and a profit for longs of 127.7%.

To the downside; UYG performed 152.8% over XLF.

To the upside; UYG made 314.6% over that of XLF. Performing like a 3x in percentage basis.

FAS which is a 3xETF of XLF made 581% price appreciation over XLF during the same 10 days rally in March 2009.

That is how compounding by 2x and 3x works over time.

Compounding works much better for long-term investors rather than for short-term traders since if you buy and sold at the same day, you will never benefit from price compounding.

Do your math.

Apr 11 11:56 PM

[The AntiCramer:]

As several have said already these things aren't easy to short. Plus add on the cost of holding the shorts. Then, if we don't have a sideways market for 5 months and instead move quickly in one direction or the other you're either rich or toast.

You'll probably get it right though. Cheers.

Shorting two inverse ETFs that are comprised of all kinds of frankenstein securities isn't arbitrage. Its a wolf in sheep's clothing.


On Apr 10 12:10 PM arthatek wrote:

> short them both and make 81% in 5 months. what could go wrong ?

Apr 12 10:50 AM

[wasabi:]

should I buy Faz tomorrow morning? do you think it will go back up dramatically tomorrow morning?

Apr 12 11:33 PM

[wasabi:]

should I buy Faz tomorrow morning? do you think it will go back up dramatically tomorrow morning?


On Apr 08 03:48 PM Ron Rowland wrote:

> "...pairing a long & short position that track the same index
> is a prime case..."
>
> Wouldn't it be easier and cheaper to sit in cash than do what you
> are suggesting? Or take a smaller position of just one if you are
> equally weighting the two?

Apr 12 11:34 PM

[Lee Eugene ...:]

Just remember from the excellent articles on thestreet.com by Eric Oberg - here is the link - www.thestreet.com/stor... -
I trade them, have not figured out the arbitrage yet, but the bottom line is that you are dealing with not simply the index itself, but the second derivative of volatility. Essentially, you are playing options and don't even know it. That is why Cramer and crew are so pissed off. Have fun and be careful with them!!!!

Apr 13 10:23 AM

[Everyday Fi...:]

In early March, I had entered into a hedged combination of ETF long and option calls strategy. It's worked out well, but primarily only due to the mass move upward that insued (I got very lucky w timing), which I had somewhat expected (or else I would have taken a bath on both sides of the position). Somewhat long explanation, but if you believe Financials have much more up/down exposure, this can work in a hedged fashion:
everydayfinance.blogsp...

Apr 13 02:23 PM

[Shabba:]

I'm new to ETFs and haven't invested in one before. I have a very basic question though, what keeps these things balanced?

For example suppose the underlying basket of stocks increases by 5% that the ETF represents in one day, is there some type of mechanism to ensure the ETF goes up 5% (assuming it isn't one of the levered ETFs)?

It doesn't seem like there is anything to force this, and you can't redeem your shares directly from the ETF for the individual stocks so there isn't an arbitrage opportunity. It seems like ETFs are promoted as representing a basket of stocks when in reality their performance is different because you have essentially created a new security by combining everything and not forcing the ETF to actually represent the underlying stocks. Or am I wrong about this?

Apr 13 06:18 PM

[Ron Rowland:]

Shabba, most ETFs have a mechanism called an in-kind exchange that lets Authorized Participants (APs) trade a basket of the underlying securities for the ETF or vice-versa (this is also called share creation and redemption). If the prices get out of whack, then the AP steps in and can arbitrage the difference, and repeat as necessary until the difference isn't worth chasing.

This system works quite well for most ETFs and ETNs, but there are exceptions.

Apr 13 07:20 PM

[Shabba:]

Thanks for the answer. Good article too! It was very informative.

Apr 14 03:33 PM

[oilinc:]

Wasabi
I've decided the only way you should buy FAZ or FAS ever, is if you know which way the financial market is moving. If it moves in your favor from the get go you'll be in great shape. But when it moves against you, it wipes out your capital so fast, you're unlikely to recover.
Consider this. A 20% move against you(which only needs a 7% move in the index) will now require a more than 100% move in your favor(34% move in the index to recover).

May 17 05:43 PM

[oilinc:]

Wasabi
My bad. A 20% move in the index against you, will now require a 34% move in your favor to break even. Not a reasonable risk in my opinion.

May 17 05:48 PM