ETF – Page 8 – OneMint

How does a Leveraged ETF make money?

Leveraged ETFs are a relatively new species of rapidly growing ETFs, that have already crossed the $6 billion dollar mark – for assets under management.

Leveraged ETFs track an index, commodity, currency or sector, and target double or triple daily returns of the index. So, a 2X Leveraged ETF that tracks oil prices will gain 10%, if oil gains by 5% in a day. By their very nature, Leveraged ETFs provide daily returns, and are rebalanced every day. That means – a 2X Leveraged ETF will return 4% in a day – if the underlying index rises 2%, but it will not return 4% over a week, if the index rose 2% over the week. For an explanation of this visit this example of daily leveraged returns from a Leveraged ETF.

How does a Leveraged ETF make money?

While the functioning of each leveraged ETF will differ from another; at a high level – Leveraged ETFs invest in a mix of short-term fixed income investments (like US Treasuries, bank deposits, money market funds, repo agreements) and derivative options.

The cash and cash equivalents (like T – Bills) provide collateral for buying derivative instruments, which are then used to create an investment vehicle that returns twice or thrice the underlying asset.

The most common instruments that Leveraged ETFs invest in are:

1. Swap Agreements: A swap agreement is an agreement between two institutional parties that exchange returns for a particular period of time based on an underlying asset. For example, in an – Interest Rate Swap – two parties will agree upon a notional amount, one party will pay the other a fixed rate of interest, while receiving a – floating rate – pegged on something like LIBOR.

2. Forward Contracts: A – Forward Contract – is a contract between two parties – to carry out a transaction on an asset at a future date on a predetermined price.

3. Future Contracts: Futures are like Forwards, but the difference is that Futures are traded on a stock exchange and can be bought or sold at any given time. As opposed to Forwards whichÂ can be executed only at a certain future date.

4. Options: Call and Put Options of the underlying asset are traded by Leveraged ETFs, in their regular dealing.

At any point in time, a Leveraged ETF holds a combination of these instruments, such that, they return twice or thrice the underlying asset in a day (based on the fund type).

Apart from the Options – the Beta of the other contracts has to be 1 or close to 1, so that the fund moves in tandem with the underlying asset. The Leveraged ETF constructs this combination of instruments every day, and trades it daily in order to be perfectly aligned with the goal of returning twice or thrice the index.

Do not use a Leveraged ETF for Hedging

When I read about a – Leveraged ETF, for the first time – I wondered – who will be interested in such a product?

Leveraged ETF is: too fancy a product for long-term investors, or even other ordinary investors. I think a person who can be interested in an ETF, that is good, only, for a day (and understand that fact) should be sophisticated enough to buy derivative options himself, and create a similar product. This will save a lot of costs, and will certainly be a lot more exciting, than simply buying an ETF.

Hedging with a Leveraged ETF

Then I came across this interesting question in The Dividend Guy’s website – Could you hold 75% of your portfolio in stocks, and buy 3X Leverage Funds that short the market?

So, theoretically, you have 3/4th of your portfolio in common stocks, and 1/4th of your portfolio is invested in a product that shorts the market 3 times.

While, the idea itself is good, the daily nature of Leveraged ETFs do not allow them to be the right tool to execute this strategy.

A Leveraged ETF uses daily leverage and that is what makes all the difference – Daily Leverage. Let me take an example of how this would work:

Suppose, we have an Index and it moves in the following manner:

Day 1, Index Value – 1000

Day 2, Index Value – 1050 (Gain of 5%)

Day 3, Index Value – 1000 (Loss of 4.76%)

An ordinary ETF will give you no profit, no loss – in such a situation.

However a Leveraged ETF, thatÂ needs to lever itself every day will move in a different manner. A 3X fund will gain 15% on the first day, and then lose 14.28% (4.76 x 3) in the second day.

Here is how it will look:

Day 1, Index Fund – 1000

Day 2, Gain of 15% on 1000Â Â Â – 1150

Day 3, Loss of 14.28% of 1150 – 985.78

So, even though the market didn’t move at all – you stand to lose money on your investment.

When looked at it from a Hedging perspective – your portfolio of stocks has netted you no gain, but, your Leveraged ETF has caused you a loss.

That makes this product really bad for hedging. Unless, of course – you have the time and ability to counter the daily leverage, and balance your ETF investment daily.

What else can you do with a Leveraged ETF?

You can lose a lot of money.

This product is not for any investor – who wants to hold their money in a derivative instrument for more than a week.

I share the same skepticism as Invest Skeptically, when it comes to this new product. The fee is high, tracking error should be high (although I don’t have data on this), it is a leveraged product – so there is a risk that the counter – party will default, and it is too complicated a financial product; to execute it successfully, and without losing a lot of money.