Geared investments gain traction

Short and leveraged (S&L) ETPs have been growing in popularity since their arrival on the market nearly 15 years ago. With AUM under USD 100mn in 2005, they now represent approximately USD 80bn in assets under management as of year-end 2019. Discussed in a previous article, it’s quite evident why they have won over investors’ approval worldwide.

A key benefit of S&L ETPs is their variety. There are ETPs giving exposure to currencies, commodities, debt, and alternatives. Nevertheless, equity remains the crown jewel as approximately 85% of investments are directed towards equity indices and benchmarks1. Hence, sophisticated investors have been able to use these methods of tactical trading to complement their traditional ‘buy and hold’ strategies.

Structure of leveraged ETPs

One discouraging attribute of leveraged ETPs until now has been their form of replication. Until recently, companies offering these products (including leveraged ETFs) have been able to achieve the needed amount of gearing via synthetic replication. This means that the ETP is not backed by the underlying asset but instead the company enters into a total return swap agreement or futures contract with a counterparty. Sometimes as little as 10% of the capital is actually invested in the equities being tracked. Although backed by collateral, this type of replication still exposes the ETP investor to additional perils as they now have exposure to both market and counterparty risk.

Let’s get physical

A distinguishing feature of Leveraged Shares ETPs is that all of the products are physically backed. A $100 investment in one of our ETPs gives the investor an exposure worth $200 to the underlying security (excluding fees), as Leverage Shares invests all of the cash proceeds in the securities being tracked.
    1.     Initial allocation

If the 2x ETP has $100 in net assets, $200 of net exposure to the ETP assets needs to be maintained.

    2.     Underlying stock price increases by 5%

When the index rises 5% during the trading day, the ETP rises by twice that amount (10%) and the total exposure to the ETP rises to $210.

    3.     ETP exposure modified

As exposure needs to be two times that of the ETP assets ($110 x 2 = $220) at the beginning of each trading day, an additional $10 of underlying securities must be purchased to maintain the needed exposure of 2x.

In the opposite scenario, where the ETP value falls to $90 due to a 5% decline in the underlying stock (meaning a $10 fall in ETP value), the exposure would fall to $190 during the day. Thus, to maintain the 2x multiple, the total exposure to the ETP would need to be reduced by $10 ($90 x 2 = $180).

So where does the additional capital for the needed leverage come from? When an ETP is issued, that entire proceeds plus a matching margin loan provided by Interactive Brokers is invested in the underlying security (stocks like Amazon and Netflix). Moreover, additional cash proceeds (like dividends received from the underlying securities) are also invested to purchase additional securities. In this manner, the 2x ETPs are always fully collateralized.

SOURCE: 1. Wisdomtree, “SHORT & LEVERAGED ETPs Global Flows”, December 2019.