Luck's Role In Leveraged ETFs

I get a lot of emails from ETF investors. And for every email I get asking what seems like a simple question, I always assume there are 1,000 other folks out there asking the exact same question.

With permission, I wanted to answer one of these emails publicly. I’ve paraphrased the question here for length:

“Dave,

I have bought and sold the Direxion Daily S&P 500 Bull 3x Shares (SPXL) since end of August 2017. I kept the first purchase for over two months and then sold and bought more again.

Question 1: The balances in my portfolio match the prices of the shares on the days they were bought and sold. Are expense ratios, fees, etc., included in the purchase or sale market prices, or will they be charged at a later date? If so, what is the percentage and when?

Question 2: What is the reason that analysts advise very-short-term trades for this ETF? They say this ETF should be traded for only one day; why so? I am watching my account on a daily basis and have a sell stop quote on my shares in case large losses take place when I am not looking, so why should I be afraid to trade SPXL?”

Both of these fall cleanly under an umbrella of “things we take for granted.” The “we” in this case being “ETF nerds like Dave.” And the amazing thing is that the two questions here are actually both incredibly simple, and surprisingly subtle.

Is An ETF A Stock Or A Mutual Fund?

Let’s take the first one. The short answer to the question of “when are fees taken out” is “at the end of every day.”

But that’s not actually intuitive. From an accounting and structural perspective, most ETFs are just mutual funds under the hood. Like a mutual fund, they have a net asset value (NAV) that’s calculated every day by a fund accountant.

That calculation is also pretty simple: You take all of the assets of the fund, and you subtract all of the liabilities. Then you divide the big number by the number of outstanding shares.

What gets tricky is that assets and liabilities are constantly changing. Sure, the value of the stocks the ETF holds go up and down, but an ETF is just a company, from an accounting perspective, so every day it also has some small amount of income, from things like dividends or maybe securities lending, and expenses, such as what the fund owes the fund manager.

So every day, what the fund is owed, and what the fund owes, is taken into account in that NAV calculation. The fund might only cut a check to the fund manager once a quarter, but every day, the amount owed for that day’s management is counted as a liability, no matter how small.

What complicates things is that ETFs, unlike mutual funds, don’t trade at NAV. The end-of-day calculation simply serves as a benchmark around which the rest of the market decides what to bid or ask for shares in the open market. And of course, that moves around all day during the trading day, based on how the holdings of the fund move.

But ever so slowly, that benchmark slides downward as the expenses are accounted for, day after day. If the markets were literally completely flat on a given day, you’d expect the price of every ETF to go down just a fraction of a fraction of a percent.

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].