Innovation has been on display in the ETF industry in recent years, as various issuers have been active on the product development front in their efforts to bring new and exciting products to market. One area that has seen tremendous growth is the leveraged ETF space. Investors have embraced the exchange-traded structure as an efficient means of amplifying exposure to everything from Chinese stocks (YINN) (YANG) to gold (UGL) (GLL) to long-term Treasuries (TBT) (UBT).
In total, there are nearly 200 leveraged ETPs covering dozen of different asset classes. But not all leveraged exchange-traded products utilize the same structure. There are some nuances across the roster of these funds that can have a significant impact on the risk/return profile offered. Most investors are aware of the differences between ETFs and ETNs, including distinctions in credit risk, tracking error, and sometimes tax ramifications as well. But some don’t realize that the reset frequency can also vary from product to product, and that the timing of such resets can have a major impact on the volatility and potential returns of a product.
The majority of leveraged ETFs feature daily resets of exposure, meaning they are designed to deliver amplified returns over the course of a single time period. The Direxion Daily Small Cap Bear 3x Shares (TZA), for example, is designed to deliver daily returns equal to -300% of the daily change in the Russell 2000. It maintains that same objective every day of the week, regardless of how markets performed the previous day. And as a result, the performance over multiple trading sessions is path dependent. The performance of the ETF will depend not only on the change in the index over the time period in question, but in the nature of the path taken. In trending markets, gains will generally be enhanced and losses limited. Seesawing markets, on the other hand, will erode returns.
No Reset ETPs
Not all leveraged products reset exposure on a daily basis. PowerShares and UBS, among others, offer ETFs and ETNs that reset exposure monthly, meaning that they seek to deliver amplified results over a much longer period of time. And then there are a number of products from iPath that never reset exposure, seeking to deliver leveraged results over the life of the exchange-traded note (generally 10 years).
The concept of no resets to leveraged exposure over an extended period of time can have an interesting impact on the risk/return profile offered. Investors getting into these products know the effective leverage multiple they will realize at the time of purchase; the “path dependency” is essentially removed. It’s also interesting to note that this methodology can result in effective multiples that dwarf the 2x and 3x exposure offered by daily reset ETPs. Currently, the effective leverage offered by various no-reset inverse and leveraged ETNs ranges from just 0.10x to nearly 8x.
To understand just how effective leverage can creep toward double digits, we’ll walk through a simplified example. Suppose that an ETN is designed to deliver 2x leverage to a stock index over the course of 10 years. To simplify the scenario, assume that both the index and the leveraged ETN start at a value of $100.
In the first month, the value of the index falls to 80, representing a decline of 20%. The 2x leveraged ETN would therefore be down 40%, which translates into a price of $60 per share:
|Leveraged ETN Nuances|
|Period||Index Value||Index %||ETN Value||ETN %|
Now suppose that you establish a position in the ETN at $60 per share. The next day, the underlying index rallies 2%, closing at $81.6, or down 18.4% since the inception of the note. The 2x leveraged ETN would then have a value equal to 63.2% of its original value, or $63.20 (the note would be down 2 x 18.4% = 36.8%). So the gain realized by the investor who bought in at the beginning of that day would be $3.20 per share, or about 5.33%. The effective leverage realized was not 2.0x, but closer to 2.7x.
|Leveraged ETN Nuances|
|Period||Index Value||Index %||ETN Value||ETN %|
This phenomenon is, of course, two sided. Suppose that instead of climbing 2%, the index lost another 2% and fell to $78.40. The 2x leveraged ETN would then be down 42.6%, and would be worth $57.40 per share. The loss of $2.60 per share would be 4.3% of the $60 investment, more than two times the decline in the index.
Rules of Thumb for “No Reset” Leveraged ETNs
The example outlined above is simplified. There are some nuances to the manner in which values of ETNs are calculated that make the picture a bit more complex. But the general mechanism is relatively easy to grasp. If no-reset leveraged ETN has gained value since inception, the effective leverage has declined from the initial amplification multiple. (iPath has put together a nice guide to the leverage mechanisms employed by its products.)
A great example of that phenomenon is the iPath Inverse S&P 500 VIX Short-Term Futures ETN (XXV), a leveraged ETN that was designed to deliver returns equivalent to the inverse of an index comprised of short-term VIX futures over the lifetime of the note (i.e., a lifetime leverage target of -1x). Since debuting in July of last year, XXV has gained about 75%. Now, the participation ratio for the ETN is about 0.10%, meaning that those establishing a position now won’t experience movements that correspond to the inverse of the related index.
On the flip side of the coin are products such as the iPath Short Extended Russell 2000 TR Index ETN (RTSA), which is designed to offer -3x exposure to the popular small cap index between its inception in late 2010 and maturity in November 2020. The Russell 2000 has rallied since RTSA launched, and as a result, this note has performed poorly (RTSA had recently lost more than 50% of its value since inception). The strong performance of the underlying index also had a dramatic impact on the effective leverage offered by the note. Recently, RTSA featured a participation ratio of more than 8.3. When the iShares Russell 2000 Index Fund (IWM) lost 0.6% last Friday, RTSA was up a robust 4.8%. Not bad for a day’s work.
There is of course a downside to that extreme leverage. If the Russell 2000 climbs, investors in RTSA will get hammered. That’s why many risk-hungry investors seeking to leverage up exposure to a particular asset class will gravitate toward the daily leveraged ETFs offered by ProShares and Direxion. Those funds reset exposure on a daily basis, and as such will maintain more predictable leverage factors (though the amplification percentage will vary throughout the course of a trading session, just as the participation ratio of RTSA changes over the course of that note’s leverage period).
Disclosure: No positions at time of writing.
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