A Leveraged ETF Investor’s Checklist

If you’re trying to capitalize on huge price swings in commodities or anything else, how you get from A to B matters.

Looking to make geared bets on volatile price swings in assets like oil or energy stocks? You’ll need to get three things right to achieve the best performance.

The first two are clear: timing and the direction. A trader betting that oil would sink in November would have done well in inverse-double-exposure or inverse- triple-exposure oil ETFs.

The third factor is the actual pattern of returns, and its impact is clear: Choppy returns hurt performance, and strong trends help in a geared fund, whether you’re short or long.

In case you were wondering about the complexity of what we’re getting into here, consider that any prospectus detailing a leveraged or inverse security pretty much says that such ETFs need to be watched closely and are really designed for sophisticated investors. Translation: Most investors probably shouldn’t try this at home.

My purpose here is to shed a bit more light on what “watched closely” means.

Path Dependence In The Real World

You can see this in real-world data by looking at performance of pairs of geared funds. Oil’s drop in November was especially sharp and steady toward the end of the month. No doubt, the short fund beat the pants off the long fund, but the comparison point is to the triple-exposure returns you’d expect.

Specifically, I’m comparing the VelocityShares 3X Inverse Crude Oil ETN (DWTI) with the VelocityShares 3X Long Crude Oil ETN (UWTI).

In November, oil dropped 16.0 percent, so you might expect a 48.0 percent for the triple-exposure bearish fund, DWTI. However, it did even better: 55.0 percent. Meanwhile, the triple-exposure long fund UWTI lost less than it should have at -44.0 percent rather than -48.0 percent in November.

Clearly, getting the direction right mattered most in November, as it does most of the time. But the strong trend provides subtext of relative outperformance versus expectations.

In September, oil’s performance was choppy with no strong trends. Geared funds—both short and long, suffer in this environment.

Oil was down slightly in September at 0.96 percent, so you’d expect about a 3 percent return for the tripe-exposure bearish fund. Instead the “-3x” DWTI barely broke even at 0.4 percent, while the triple-exposure long UWTI fund did even worse than expected at -4.1 percent.

To recap, in November, getting the direction right was crucial. In September, the nature of the actual path of daily returns played a larger role. The pattern of returns can even overwhelm the directional call. By that I mean an inverse fund can still lose money even if the underlying index is down in choppy markets, assuming the investor does not rebalance exposure.

Path Dependency At The North Pole

A hypothetical example, one in the spirit of the season, also demonstrates the impact of the strong trends versus choppy returns on geared performance.

Imagine two elves, each making big bets against their favorite commodities—sugarplums and gingerbread—in the two weeks before Christmas using bearish triple-exposure ETFs. After the two weeks have elapsed, each bet has been proved right in both direction and timing: Each commodity has dropped, let’s say, by exactly 10 percent.

Each elf expects a sweet 30 percent return. However, the volatility that’s apparent in the “gingerbread” chart above hurts returns, lowering them to 26 percent, while the smooth drop in the sugarplum index makes a great bet even better, lifting gains to 35 percent. (The returns are hypothetical, but the math is real for daily resetting triple-exposure securities.)

Hypothetical 1x levels. Hypothetical ETF returns are calculated based on daily resetting -3x exposure.

Rebalance To Get Your Desired Multiple

Traders can rebalance their positions to lessen the impact of this path dependency.

To clarify, the ETFs reset their exposure daily to their target (3x) multiple. But as an investor, you need to rebalance your exposure to the ETF to maintain that 3x multiple over time by buying or selling incremental amounts to true-up your exposure. To be clear, that means buying more shares of the ETF if the performance is below the 3x multiple or selling if it's above.

The takeaway: Leveraged and inverse ETFs are powerful tactical tools. Traders holding the funds for longer than a day without rebalancing their positions can benefit or suffer from the path dependency, unlike a position in an unleveraged stock or bond ETF.

Again, the solution is to rebalance your position in the ETF to maintain the desired exposure.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.