Luck's Role In Leveraged ETFs

November 02, 2017

Bigger Question: Leverage

The good news here for our emailer is that he’s asking a very smart question in the second half. He’s heard the mantra we’ve all been chanting for years: Don’t buy and hold leveraged products.

We must seem like idiots. Since the end of August, SPXL is up 14.4%, and the S&P 500 is up 5.24%. He’s making money. Sure, it’s not precisely 3X the S&P 500, but it’s not bad!

The problem is that we’ve been in a very-low-volatility market, which tends to work very well if you hold a daily-reset levered product like SPXL. Just scrolling back to a higher volatility era shows a few-months window where you ended up in a very different place:

In this window, the S&P was up a modest .82%, but the 3X fund, instead of getting you 2.4%, actually lost you over half a percent. The reason here is actually pretty simple math.

Imagine you have an ETF promising 3X the daily return of something. On day one, both indexes are at 100:

 

Day 1:                 

Index Level:                           100

3X ETF Level:                       100

 

Then, the index has a terrible day, and goes down 10%

 

Day 2:                 

Index Level:                           90              

3X ETF Level:                       70

 

Simple, right? The index falls 10% to 90, the 3X ETF goes down 30% to 70.

Now imagine on day 3, the index recovers 15%! Huzzah!

 

Day 3:                 

Index Level:                          103.5                  

3X ETF Level:                      101.5

 

So, 15% of 90 is 13.5, so the index climbs back above water for a total return of 3.5% for the two days of excitement. The 3X ETF goes up 45% from 70, which is 31.5 points, to reach 101.5, or only a 1.5% total return. Two days into your holding period, instead of being up 10.5% (3X the two day index return of 3.5%), you’re only up 1.5%.

Of course, the market rarely moves this much in a two-day window, but the same math works out day after day in a thousand small cuts. If the market has any volatility, the daily reset math creates a radically different pattern of returns than you might expect.

That’s why, gentle emailer, we’re always saying that holding a leveraged product for more than a day can have unintended consequences. In this case, you’ve managed to do OK. But that’s really just random luck.

ETFs are great tools. But don’t just assume that because things “look” a particular way (you can’t see the fees, leverage seems to just work out) that they are in fact that simple.

At the time of writing, the author held no positions in the security mentioned. Contact Dave Nadig at [email protected].

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