In addition, a leveraged ETF may enter into an index swap agreement with a counterparty to increase its exposure to the underlying index. Swaps are customized agreements between two counterparties to exchange two sets of cash flows over a specified period of time. In an equity index swap, one party generally pays cash equal to the total return on the underlying index, while the other pays a floating interest rate.
The process for constructing a -2x leveraged ETF has some similarities. Because such a fund would be designed to deliver exposure equivalent to a multiple of the inverse return on a benchmark, it could keep a significant portion of its assets in cash, which would be used as collateral for futures and swaps contracts that would increase in value if the related benchmark declined:.
Much of the confusion over leveraged ETFs relates to the rebalancing process. In order to deliver results that correspond to the indicated multiple of daily returns on an underlying index, leveraged ETFs must rebalance their holdings on a daily basis. There are a number of ways for the fund to do this, most of which involve the use of various derivative products. It is this rebalancing process that creates the potential for divergent results if leveraged funds are held for multiple trading sessions.
Simulating daily rebalancing is mathematically simple. All that needs to be done is to double the daily index return. What is considerably more complex is estimating the impact of fees on the daily returns of the portfolio, which we'll cover in the next section. Assuming that future returns conform to recent historical averages, the two-times leveraged ETF based upon this index will be expected to return twice the expected return with twice the expected volatility i.
Most of this gain would come in the form of capital gains rather than dividends. However, this 1. Leveraged ETFs incur expenses in three categories:. The management expense is the fee levied by the fund's management company. These fees cover both marketing and fund administration costs. Interest expenses are costs related to holding derivative securities. All derivatives have an interest rate built into their pricing. This rate, known as the risk-free rate , is very close to the short-term rate on U.
Buying and selling these derivatives also results in transaction expenses. Interest and transaction expenses can be hard to identify and calculate because they are not individual line items but instead a gradual reduction of fund profitability. One approach that works well is to compare a leveraged ETF's performance against its underlying index for several months and examine the differences between expected and actual returns.
The fund maintains a large cash position to offset potential declines in the index futures and equity swaps. This cash is invested in short-term securities and helps offset the interest costs associated with these derivatives. Every day, the fund rebalances its index exposure based upon fluctuations in the price of the index and on share creation and redemption obligations.
This example does not take into account daily rebalancing and long sequences of superior or inferior daily returns can often have a noticeable impact on the fund's shareholdings and performance. Behind the scenes, fund management is constantly buying and selling derivatives to maintain a target index exposure. This results in interest and transaction expenses and significant fluctuations in index exposure due to daily rebalancing.
Because of these factors, it is impossible for any of these funds to provide twice the return of the index for long periods of time. The best way to develop realistic performance expectations for these products is to study the ETF's past daily returns as compared to those of the underlying index.
For investors already familiar with leveraged investing and have access to the underlying derivatives e. These investors will probably be more comfortable managing their own portfolios, and controlling their index exposure and leverage ratio directly.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. The market environments that worked out best for leveraged ETFs were those like the past 15 months: a strong upward move in the market together with fairly low day-to-day volatility. In such cases, the new shares the fund purchased each day rarely had to be sold at a loss when the market dropped. When you understand how leveraged ETFs work, this finding makes sense.
A sideways market with a lot of volatility would see the market whipping back and forth. The fund managers would get caught again and again in the Constant Liquidity Trap as they rebalanced the fund each day to its leverage target. Without an upward trend, the investor would never get the chance for a sustained win. Steven C.
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