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Leveraged ETFs: Beware the Performance Conundrum

Compounding works better to the long side than to the short side. Simply make that calculation assuming 10 consecutive days of rally and 10 consecutive days of selloff with 5% rally/selloff per day and you will realize how compounding works on the upside and the upside.

That aside; it is true that some xETF perfoms quite horribly against underlying index they track.

And then look at 3x ETF such as FAS and FAZ. If the BKX went down a lot further than 17.75 in March 2009 while FAS was printing $2.32 at that time. If BKX went down to 15.00, Fas might as well has gone below zero which is an impossibility. BKX did not go down to 15.00. But the question remains the same, what would have happened to FAS at that time with $2.32 value if BKX goes down more than 1.01 from 17.75. FAZ should be zero by then being a 3x.

Likewise, FAZ went down from $115 to $9+ with BKX retracing less than 20% of it's total selloff from 121 top to 17.75 March 2007 bottom - BKX made a rally to 33+ from 17.75. FAZ lost $105 when BKX almost doubled from March bottom.

What if BKX retraces even 50% of the total selloff from 121 to 17.75?. Meaning BKX making a rally from current 33+ to 69. BKX would more than double from current price . Would FAZ lose more than $105 by then? That would be an impossibility since FAZ right now is only worth less than $10.

What happens if those 2x and 3x ETFs go down to zero and the underlying index kept going against them. Will they be considered bankcrupt?

This is a problem xETF managers will have to address and correct immediately.

Leveraged ETFs: Is Tracking Error Really So Troublesome?

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.

Boy - that is the effect of price compounding to the upside! Remember, when you deposit $10,000 into the bank and don't withdraw the interest profit everyday, that profit will earn interest the next day - and so on and so forth. $10,000 will double in 16 years with 5% interest compounded yearly. While without compounding, it will require 20 years to double.

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

Do your math.