Short and Leveraged ETPs are designed around the daily performance of their
underlying asset and are intended to be traded intraday. They have a
fixed level of leverage (-3x, +3x, etc.) which makes it easy to determine
how the price of a Short and Leveraged ETP will move during a single
trading day, which is simply the leverage factor times the daily
performance of the underlying benchmark.
Investors may hold Short and Leveraged ETPs for longer than one day;
however, the cumulative returns could be larger or smaller than the leverage
factor implies. This is because the ETPs are “reset” at the end of each
trading day.
The daily resets of leveraged ETPs cause a compounding effect, which means
that the gains or losses from one period affect the base from which the
next period’s returns are calculated. As the base increases or decreases,
the leveraged return also gets larger or smaller in each subsequent period.
Therefore, the return for any given period will depend on both the
percentage gain/loss for that period, plus any cumulative gain/loss on the
initial investment.
Compounding can have both positive and negative effects and investor
considering holding leveraged ETPs for extended periods is important to
fully understand that there could be a significant difference between the
ETP performance, and the benchmark performance multiplied by the leverage
factor.
The compounding effect can positively enhance returns in trending markets
(upward or downward) whilst negatively impacting returns when the markets
are more volatile or choppy.
Daily returns in an up-trending market
Let’s have a look at an example which show the cumulative performance
of an underlying asset which rises 5% every day, for ten days in a row,
and a 3x Leveraged ETP, which delivers 3x the daily return of the
underlying instrument.
• The underlying asset rises 5% each day for 10
consecutive days.
• The 3x Leveraged ETP rises 15% each day for 10 consecutive days.
• Investors may expect that the ten-day return would produce 3x the
cumulative return of the underlying i.e., 189% (3 x 63%), while the
cumulative return of the ETP is 305%, as the compounding effect has
outperformed the sum of the daily returns.
Daily returns in a down-trending market
Let’s have a look at an example which show the cumulative performance
of an underlying asset which falls 5% every day, for ten consecutive
days, and a 3x Leveraged ETP, which delivers 3x the daily return of the
underlying instrument.
• The underlying asset value falls by 5% for
ten days in a row.
• The 3x Leveraged ETP falls 15% each day.
• Investors may expect that on day 8 the 3x Leveraged ETP would lose its
entire value (-100%), while the cumulative return of the ETP for the
ten-day period is -80%, as the compounding effect has outperformed the sum
of negative daily returns.
Daily returns in a volatile market
Let’s have a look at an example which show the cumulative performance of an
underlying asset which rises and falls by 5% continuously, for ten
consecutive days, and a 3x Leveraged ETP, which delivers 3x the daily
return of the underlying instrument.
• The underlying asset value rises 5% on day
one, then falls by 5% on day two, and so on.
• The 3x Leveraged ETP rises 15% on day one, then falls by 15% on day two,
and so on.
• Investors may expect that the ten-day return would produce 3x the
cumulative return of the index i.e. – 3.73% (3 x -1.24%), while the
cumulative return of the ETP is -11%, as the compounding effect
has underperformed
the sum of daily returns.
In conclusion:
The key factors of compounding are:
• Investment returns for periods longer than one day are affected by
compounding
• Daily compounding can have either a positive or negative effect on
returns
• For periods longer than one day, daily compounded returns may not be
equal to an unleveraged return (or the benchmark index) multiplied by the
leverage factor
• A trending market (upwards or downwards) will result in returns which
appear to “outperform”
• High volatility or a sideways trending market will result in returns
which appear to “underperform”
• The compounding effect increases with higher volatility, greater leverage
and longer holding periods
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