Beyond the short run

The most common use of leveraged exchange traded products (ETPs), by both private and institutional investors, is for daily trading. This is unsurprising, especially for the retail investors that operate with less capital, as they consider leverage a means to boost their bet. The leverage, nevertheless, plays a fundamental role in managing a targeted exposure to a certain underlying security. Fund and portfolio managers can obtain the desired exposure and better allocate their resources as a result of leverage. For this reason, the use of derivatives and leveraged products is frequently longer than a trading day. Leverage Shares ETPs have some key features that can be flawlessly amenable to the desired management of a portfolio over time.

Unlike other products that are based on derivatives, Leverage Shares ETPs are physically backed by the purchasing of the underlying shares and they are easily tradable via listings on the LSE and Cboe Europe. Moreover, we have to accentuate their feature of being based on individual shares of popular companies, which are omnipresent in almost every benchmark and portfolio – a helpful tool for tactical and satellite strategies.

When we mention Google, Microsoft, Apple, Goldman Sachs, and the likes, we are naming companies to which many of us, in our portfolio directly or within an ETF / mutual fund, have exposure. The same applies to institutional investors, particularly when they must track an equity index, or they are rated for the excess return over a benchmark. Trading on those blue chips is clear since the volumes in their order books are extremely high and the speculation is always an extra weapon for the liquidity. However, from a strategic viewpoint, it is also not farfetched to have a buy-and-hold strategy on those dominant companies, as long as they reveal a solid and growing business, backed by robust future plans.

Volatility makes price fluctuations appear like a lottery in the eyes of a novice investor, but a company has a fair value which is continuously assessed. Basically, an enterprise value depends on the invested capital plus the present value of future free cash flow to the firm. It is precisely the tricky estimation of the future economic value added, combined with current events and the human emotions that result in market volatility. The outcome of the large swings is that some traders find an ace in the hole and natural selection stops out the beginners trying to beat the market. Hence, volatility is the pain that investors must deal with in order to realize their expectations over time. There is no such thing as a free lunch!

The management of a portfolio is fundamentally based on asset allocation, stock picking, and short-term tactical strategies. It goes without saying that an investor needs to discover a pool of companies with strong growth figures and a positive outlook, then implement a buy-and-hold strategy. In this article, for empirical purposes, we allude to Amazon (AMZN) stock and Leverage Shares 2x Amazon ETP (AMZ2) to exhibit how long leveraged ETPs may complement a strategical position on a share.
Everyone knows Amazon and how the company, initially operating out of a garage, has become influential and present in many aspects of people’s lives. The investors that have instilled their trust in Amazon since 1997, when priced at 18 USD following its IPO, are still embracing their decision. The exponential increase of its share price is continuing, evident from the chart for the last four years (above). When solvency and liquidity ratios are adequate, revenues/cash flows or other measures of profit have been on an uptrend, the return on the investment is quite predictable. Looking at Amazon’s balance sheet over the last years makes these notions of financial statements analysis fairly straightforward. Past performance is not indicative of future results, and this paper does not aim to advise or recommend any investments.

Nevertheless, the past can help you learn and refine your investment approach, to exploit suitable tools to support your conviction. For this reason, Amazon is just a sample of a share we would have wanted in our portfolio in the last years, Leverage Shares Amazon 2x ETP (AMZ2) is its leveraged counterpart. In the following cases, the AMZ2 daily price considered is the NAV. Leverage Shares ETPs are listed products, for this reason, the NAV price is indicative (although official) and obtainable precisely only at the redemption time. Nonetheless, it’s preferable to the end-of-the-day market price, which can be misleading. It is often far away from NAV and from what an investor can get in the market that day (it is the funny game of a trader).
If we broaden the comparison between the underlying share (AMZN) and the ETP (AMZ2) to the entirety of 2018-2019 (graphed above), the first thing that catches the eye is the huge effect of the leverage, even if only 2x. When an investor holds a security for more than a day, compounding prices get to work, creating an exponential function. The amplitude of this effect depends, among other factors, on the level of the leverage and time period. From the beginning of 2018 to the first days of September, AMZN increased from 1169,47 USD to 2039,51 USD, a gain of +74,40%. In the same period, AMZ2 rose from 19,98 USD to 56,63 USD (+183,43%), considerably more than twice AMZN’s performance. You can see it in the graph from the starting date to the “Top” point in yellow. In the next period of drawdown, until 21st December 2018 (point “Bottom” in the graph), Amazon price reached 1377,45 USD, a net performance of -32,46%, compared with the Leverage Shares ETP, which fell -58,27% to 23,63 USD. This real example shows how the compounding effect modifies the initial leverage over the time, giving returns different from the performance of the underlying multiplied by the coefficient (2 for this Leverage Shares ETP). The overall performance of the period 2018-2019, without any adjustments, has been in fact +58% for Amazon and +92% for the ETP (AMZ2), less than double the yield of the ordinary shares. Nonetheless, we see below how the behaviour of the ETP is in line with the index that doubles the daily price movements of Amazon for the two-year period considered.

The small difference that is created between the ETP and the Index is due to the impact of the fees. Once we understand the likely consequence of compounding, we can consider the two main reasons for using a leveraged product. The first (and most prevalent one), for a private investor in particular, is to boost returns and earn as much as possible. From their perspective, the distortion resulting from the compounding effect does not materialize into a cause for concern. Returning to the practical example above, it does not matter if the returns are not exactly double (2x). Even better, both in the positive (the gain was more than 2x) and negative period (the loss was less than 2x). However, when the leverage is employed to achieve and maintain precisely a targeted exposure to an underlying asset, using less capital to get it, the compounding effect needs to be managed and adjusted as needed. Let’s consider hedging strategies, to illustrate an example. In the positive period analyzed (from the beginning of 2018 to 4th of September), the level of the leverage becomes increasingly higher, as we can see in the chart below:
On the contrary, starting the investment in the negative period (4th September 2018 – 21st December 2018), the leverage declines further, visible on the chart below:
In this situation, an investor must adjust the exposure on the ETP periodically, to re-align the leverage coefficient with its initial level (2x in this case). Instead of operating through a margin account, as for a derivative, we must sell ETP securities (during the positive period) or to buy them (in the negative period) to maintain the leverage at 2x.

When the investors apply a buy-and-hold strategy on a single share for the long-run, they might need to increase their exposure on the underlying for short periods. We can find and summarize some reasons with the help of Amazon’s price fluctuations:
Leverage Shares ETPs come to the aid in this situation and allow investors to reach the desired exposure with fewer resources, thanks to the presence of the leverage. In case 1, taken from the upper chart, an investor could take profit on strong expected momentum of a share, deciding to increase his exposure for a while. Alternatively, he could choose to enhance the recovery period after a drawdown for a shorter (case 3) or longer (case 2) time. Case number 4 shows how an investor could determine to increase the allocation on an asset after a price drop, targeting to reach a certain value, which can be a previous peak, as in the chart. In this paper, we have limited the analysis to long strategies only, primarily a buy-and-hold approach with particular attention to the pay-off given by using leverage. Whatever the grounds for using a leveraged product, the innovative exchange traded products of Leverage Shares help investors act on their conviction, via quick, precise, and enhanced executions of single-stock strategies.