Seeking Alpha
Research analyst, ETF investing
Profile| Send Message|
( followers)  

Introduction

Leverage has been around for hundreds of years, however short and leveraged ETPs have been in existence since 2005. Today there are almost $51bn (Boost ETP Global Short and Leverage ETF/ETP Report) of assets in leveraged and short ETPs which are traded on most of the major global stock exchanges. Due to the combined features of leverage and daily compounded returns these types of ETPs are trading instruments that need to be clearly understood before an investor should trade or invest. However, once understood they are highly efficient tools that provide magnified long and short exposure in an efficient product wrapper.

The following are eight key things to know about short and leveraged ETPs.

1. Leveraged returns

Leveraged returns allow an investor to magnify the daily returns of an unleveraged investment. For example, the charts below show that if the NASDAQ 100 rises by 1% in a day, the Ultrapro Leverage QQQ (NASDAQ:TQQQ) will rise by 3% (excluding fees and adjustments). Conversely, if the NASDAQ 100 the Ultrpro Short QQQ (NASDAQ:SQQQ) falls by 1%, the Ultrpro Short QQQ will rise by 3%. Leveraged returns allow an investor to either use less of their capital to achieve a similar investment (2/3 less in the case of 3x leverage) or to magnify returns using the same amount of capital.

2. What indices do short and leveraged ETPs track?

Short and leveraged ETPs track a range of liquid, blue-chip indices published by the world's leading index providers. For example, ETPs such as Boost ETPs either track a specially designed 3x daily leveraged or 3x daily short index (such as the ShortDAX X3 TR EUR Index) that calculates the leveraged return inside the index, or they track an unleveraged index (such as the NASDAQ Commodity Crude Oil ER Index) and for which the 3x or -3x daily leverage is applied through application of a formula similar to that used by a short or leveraged index. In either case, the economic effect of both calculation methods is the same.

3. How is the short and leverage position achieved?

If an investor buys $100 of a 3x leverage ETP, the investor receives $300 of exposure consisting of $100 cash and $200 of borrowed funds (charged at the interbank lending rate) to achieve an investment of $300. The borrowing cost is deducted from the daily return and is either incorporated into the index or is incorporated in the calculation of the ETP price such that all ETPs are calculated in a similar manner.

If an investor buys $100 of a 3x short ETP the following investment is effectively made, $300 of the index is borrowed and sold short. The $400 cash ($100 from the investor and $300 from the short sale of the index) is then invested at inter-bank cash rates. The cost of the stock-borrow and interest income on the cash is incorporated into the calculation of the ETP price each day, such that all ETPs are calculated in a similar manner.

4. Daily re-balancing

Short and leverage daily ETPs rebalance their leverage at the end of every index trading day, providing investors with a 3x or -3x daily returns. This is slightly different to using margin or buying or selling a futures contract to obtain leverage. Daily "constant leverage" is used because an open-ended ETP allows for investors to buy and sell the ETP on any day and still receive the stated leverage multiple. Leverage based on a "constant dollar" amount is not possible as the amount of leverage experienced by each investor depends on the amount and day the investment was made. Monthly leverage (or some other frequency of re-balancing) could be used but then the actual leverage an investor was exposed to would depend on what day of the month they bought the investment. Daily leverage simplifies this issue.

5. Compounding - its effects

As with any investment, returns over periods longer than one day are affected by compounding due to market movements (like a bank account may compound interest over many months). Daily leveraged exposure means the compounding effect will be amplified and occur daily, which can have a positive or negative effect on returns over longer periods. If the NASDAQ 100 price is $100 and rises by 1%, the NASDAQ 100 Ultrpro Leverage QQQ ETP will rise by 3% to $103 (excluding fees and adjustments). If the NASDAQ 100 then falls by 1% the next day, then NASDAQ 100 Ultrpro Leverage QQQ ETP will fall to $99.91. Thus, over the two days the average return is 0%, however the 2-day compounded ETP return is -0.09%. The Index would also have an average return of 0% but its price would be $99.99 and its 2-day compounded return would be -0.01%. The daily compounding effect may increase with the length of a holding period, index volatility and leverage.

The charts below show the effects of compounding on returns. In the first chart labelled "Volatile Market" the index moves up and down by 2% per day. After 11 days, the Index is up by 1.8%, a 3x leverage daily ETP would be up only 4.1% (2.3x the Index) and a 3x short daily ETP is down 7.7% (-4.3x the Index). The second chart labeled "Trending Market" shows the outcome over 11 days, where the index increased by 2% each day. After 11 days, the Index is up by 24.3%, a 3x leverage daily ETP would be up only 89.8% (3.7x the Index) and a 3x short daily ETP is down 49.4% (-2.0x the Index). However, on a day-to-day basis, the 3x leverage daily ETP and 3x short daily ETP has done exactly as it is supposed to do. The effects and risks of daily leverage is explained more fully on the Boost ETP website (www.boostetp.com).

Boost inverse ETF Volatile

Boost ETF trending market chart ETF inverse

6. Intra-day crash protection

ETPs, such as Boost ETPs, have an inbuilt mechanism that is designed to prevent the ETP from falling to $0 in one day. If a market move is extreme, for example if the NASDAQ 100 falls by 20% (60% including leverage) then a NASDAQ 100 3x leverage daily ETP would rebalance intra-day to ensure that the ETP does not go to $0. This rebalancing is a similar process to the daily rebalancing which occurs at the end of every day. The intra-day rebalancing reduces the sensitivity of further falls below 20% while maintaining some exposure to a rebound. Similarly, if the NASDAQ 100 rises by 20%, then a NASDAQ 100 3x short daily ETP would rebalance intra-day.

7. Uses and trading strategies

Short and leveraged ETPs can be used by a wide range of investors for many different trading strategies:

· Treble daily returns, positive or negative (excluding fees and adjustments).

· Hedge existing positions in one simple trade

· Use in a long-short strategy using both a 3x leverage ETP and a 3x short ETP

· Use in a pair trade to take advantage of undervalued assets

· Short the market/asset class quickly, efficiently and cost-effectively

· Buying a short ETP allows the investor to profit in a falling market

· Use tactically within a broad portfolio where an investor holds strong short-term convictions

8. Leverage ETPs and possible risks

Leverage ETPs have been fiercely debated in investor circles as to whether they are risky and/or complex investments. Leverage has been around for many centuries and a multitude of financial products exist to enable investors to gain leverage and/or short exposure. An investor should understand the benefits and risks of each leverage product and see which one suits their goals and circumstances for the specific trade being considered. Short and leverage ETPs increase the tools available to investors, and used in the right way, short and leverage ETPs can enhance returns. What short and leverage ETPs do provide is a robust, transparent, exchange-traded, collateralised, secure and relatively cost efficient tool for a wide range of investors to gain leverage or short exposure, through their normal brokerage or investing channels.

Source: 8 Things To Know About Short And Leveraged ETFs / ETPs