Part 3: Rebalancing and Compounding Explained

Our Short & Leveraged Single-Stock ETPs could be challenging for some investors looking for new innovative products to add to their portfolio. In this six-part educational series, we describe the idea behind our products, their construction, features and their benefits to investors as well as when compared to other similar-seeming products.

Contents

1. Rebalancing: The Why and How

2. Daily Compounding: Often Counter-Intuitive

3. In Conclusion

Leverage Shares’ single-stock ETPs track indices by iSTOXX and NYSE in order to define their value in a transparent manner. Single-stock indices – especially those that are leveraged and inverse – produce daily returns. The daily returns aspect, in turn, influences the daily rebalancing feature of our products.

Rebalancing: The Why and How

Both leveraged and inverse indices use the end-of-day price of the underlying stock to define the closing level of the index. The fund represented by the ETP, in return, attempts to mimic this level to define the number of shares to buy or shares to sell short as closely as possible.

For instance, consider two hypothetical funds: a 2x long ETP and a -1x short ETP with the same underlying stock, in two scenarios:

• The underlying goes up by 5%

• The underlying goes down by 5%

Let’s assume that the underlying stock is at $100. The 2x long ETP’s level, or Net Asset Value (NAV), is at $100 while its exposure – the value of the shares in the fund – is at $200. Similarly, the -1x short ETP’s level is at $100 while its exposure – the value of the short positions the fund holds – is also at $100.

For the 2x long ETP, here’s how the events of the day would impact the levels and exposure of the ETP at the end of the day (EOD) and the corrective actions required:

-	EOD Level	EOD Exposure	EOD Leverage (No Rebalance)	Delta To Restore Leverage
Up 5%	$110	$210	1.91	+$10
Down 5%	$90	$190	2.11	-$10

In the instance of the underlying going up 5%, the underlying rises to $105. This means that the index level would be at $110 (since it gives 2x returns) while the exposure would be at $210. However, this means that the leverage factor has fallen to ($210/$110) = 1.91x. To restore this factor to 2x, the portfolio manager will add $10 to the current exposure to restore the desired leverage factor. By adding $10, the exposure now improves to $220. With a level of $110, the leverage factor is now back to ($220/$110) = 2x. The converse happens when the underlying goes down by 5%.

Similarly, for the -1x short ETP, here’s how the events of the day would impact the exposure of the ETP and the corrective actions required:

-	EOD Level	EOD Exposure	EOD Leverage (No Rebalance)	Delta To Restore Leverage
Up 5%	$95	-$105	-1.11	+$10
Down 5%	$105	-$95	-0.9	-$10

Note: The exposure is denoted as negative because these are short positions held by the fund. Therefore, in the case of the underlying going up by 5%, the portfolio manager will be reducing the short exposure by $10 (which, because it’s a short position, is represented as a positive value).

Thus, the daily rebalancing of the ETP is a necessary function to consistently offer the leverage and inverse positions promised to the holder of these products. However, this also brings into effect a “daily compounding” effect that can confound some investors. Let’s dig in to clarify some misconceptions.

Daily Compounding: Often Counter-Intuitive

Let’s consider two cases to highlight how daily compounding is a factor to be reckoned with:

1. No daily compounding, i.e. the portfolio manager does not make the adjustments to restore the leverage factor;

2. The ETP itself, i.e. the portfolio manager does rebalance daily, in accordance with the design of the product.

Let’s look at three scenarios:

Scenario 1: Upward Trending Market

-	-	Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7	Day 8	Day 9	Day 10	Result
2x Expectation, (No Daily Compounding)	$100.00	$110.00	$120.50	$131.53	$143.10	$155.26	$168.02	$181.42	$195.49	$210.27	$225.78	+126%
2x Leveraged ETP	$100.00	$110.00	$121.00	$133.10	$146.41	$161.05	$177.16	$194.87	$214.36	$235.79	$259.37	+159%
Underlying	$100.00	$105.00	$110.25	$115.76	$121.55	$127.63	$134.01	$140.71	$147.75	$155.13	$162.89	+63%

It can be seen that the daily compounding formula adds nearly 33% in gains over a 10-day period when compared to the expectations of a 2x investment without any adjustment for the factor restoration.

Similarly, in the case of the -1x short ETP:

-	-	Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7	Day 8	Day 9	Day 10	Result
Underlying	$100.00	$105.00	$110.25	$115.76	$121.55	$127.63	$134.01	$140.71	$147.75	$155.13	$162.89	+63%
-1x Expectation, (No Daily Compounding)	$100.00	$95.00	$89.75	$84.24	$78.45	$72.37	$65.99	$59.29	$52.25	$44.87	$37.11	-63%
-1x Leveraged ETP	$100.00	$95.00	$90.25	$85.74	$81.45	$77.38	$73.51	$69.83	$66.34	$63.02	$59.87	-41%

It can be seen that the daily compounding formula prevents a loss of nearly 23% over a 10-day period when compared to the expectations of a -1x investment without any adjustment for the factor restoration.

Scenario 2: Choppy Market

Consider a scenario where a rise of 5% in a single day is followed by a drop of 5% in the next. These kinds of “oscillations around the mean” would impact the 2x ETP’s performance as thus:

-	-	Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7	Day 8	Day 9	Day 10	Result
Underlying	$100.00	$105.00	$99.75	$104.74	$99.50	$104.48	$99.25	$104.48	$99.25	$103.95	$98.76	-1%
2x Expectation, (No Daily Compounding)	$100.00	$110.00	$99.50	$109.48	$99.00	$108.95	$98.50	$108.43	$98.01	$107.91	$97.51	-2%
2x Leveraged ETP	$100.00	$110.00	$99.00	$108.90	$98.01	$107.81	$97.03	$106.73	$96.06	$105.67	$95.10	-5%

It can be seen that an expected shortfall of 2% was magnified to more than twice that amount because of the daily compounding formula.

In the case of the -1x ETP:

-	-	Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7	Day 8	Day 9	Day 10	Result
Underlying	$100.00	$105.00	$99.75	$104.74	$99.50	$104.48	$99.25	$104.21	$99.00	$103.95	$98.76	-1%
-1x Expectation, (No Daily Compounding)	$100.00	$95.00	$100.25	$95.26	$100.50	$95.52	$100.75	$95.79	$101.00	$96.05	$101.24	+1%
-1x Leveraged ETP	$100.00	$95.00	$99.75	$94.76	$99.50	$94.53	$99.25	$94.29	$99.00	$94.05	$98.76	-1%

It can be seen that the loss in the underlying is identical to the loss in the ETP. Meanwhile, not performing the factor restoration would have provided a gain of 1%.

Scenario 3: Oscillations Around a Trending Mean

It is possible, in some instances, that the performance of the product with daily rebalancing is nearly identical to when there is none. For instance, consider the 2x long ETP in a scenario where the underlying falls by 1.9% in a day followed by a rise of nearly 4% in the next. The 10-day performance would be:

-	-	Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7	Day 8	Day 9	Day 10	Result
Underlying	$100.00	$98.10	$102.06	$100.12	$104.16	$102.18	$106.30	$104.28	$108.49	$106.43	$110.73	+11%
2x Expectation, (No Daily Compounding)	$100.00	$96.19	$104.12	$100.23	$108.32	$104.35	$112.61	$108.56	$116.98	$112.85	$121.45	+21%
2x Leveraged ETP	$100.00	$96.19	$103.96	$100.00	$108.08	$103.97	$112.37	$108.09	$116.82	$112.37	$121.45	+21%

It can be seen that the gains from the ETP mirror that of a leveraged investment without any daily rebalancing.

Now, consider the -1x short ETP in a scenario where the underlying falls by 4.96% in a day followed by a rise of 2.48% in the next. If this happened consistently over 10 days, the 10-day performance would be:

-	-	Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7	Day 8	Day 9	Day 10	Result
Underlying	$100.00	$95.04	$97.39/td>	$92.56	$94.86	$90.15	$92.39	$87.80	$89.98	$85.51	$87.64	-12%
-1x Expectation, (No Daily Compounding)	$100.00	$104.96	$102.61	$107.44	$105.14	$109.85	$107.61	$112.20	$110.02	$114.49	$112.36	+12%
-1x Short ETP	$100.00	$104.96	$102.36	$107.44	$104.77	$109.97	$107.24	$112.57	$109.77	$115.22	$112.36	+12%

In this case, it can be seen that the ETP’s performance mirrors that of simply shorting a stock.

Note: Readers should keep in mind the scenarios modelled didn’t take into account any fees or commissions.

In Conclusion

The central takeaway from this demonstration is that investing in S&L ETPs, as opposed to other means of trading with leverage or going short, has both its pros and cons. Investing in our products come with a fair bit of market risk – since these are concentrated investments in individual stocks. Needless to say, a savvy investor performing the right level of due diligence with active portfolio management practices and a keen perception of market sentiment has the potential to capitalise on market trends.