Understanding Leveraged ETFs

In this article we are discussing the mechanics of leveraged ETFs and try to understand if they are a suitable trading vehicle to replicate Trading Mate’s exposures.

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Leveraged ETFs are products that are designed to replicate X numbers of times the daily performance of an index, commodity, currency, etc.

An example of such product is the TQQQ which tries to replicate 3X the daily performance of the NASDAQ. This means that if the NASDAQ moves up 1% on a given day, the TQQQ should move up 3% on that day.

The way the fund achieves a leveraged exposure is typically via derivatives contracts like equity swaps.

While these products seem simple, there are few things that investors must take into account when deciding to use them in their portfolios. We will not focus here on aspects like the higher fees that leveraged ETF have if compared to their unleveraged counterparties, but we will mostly focus on one key aspect that goes often under the name of volatility drag.

This is related to the compounding effect and will result in the leveraged ETF’s returns to differ from the multiple of the market return they attempt to replicate, on a daily basis, even if they actually managed to offer a perfect daily tracking of the market returns. So, for example, even if a 3X product has always replicated 3X the market returns every day in the past year, it is possible that its yearly return will not be 3X the yearly return of the market.

To understand why this is happening we can look at the calculations below and use a 3X product as example:

From these calculations it is clear that the component highlighted in orange is the driver of the differences we observe over the long term between a leveraged ETF performance and the multiple of the market performance we expected to see.

It is also clear that this component will always be negative as long as the returns keep changing sign. This is what you would observe during a sideways market and it helps to explain why even if the market hasn’t moved much, your leveraged ETF exposure might have lost money.

On the other hand, this component will greatly help the leveraged ETF’s return during a trending market, i.e. when returns tend to have the same sign, since that component will add to the multiple of the market return we expected.

 

Daily rebalancing

The objective to replicate X times the daily return of the market requires the fund to rebalance its exposure to the benchmark every day by adding or removing exposure depending on the market movement. An example below, where we can see that, after a 5% gain in the benchmark on day 1, a 3X fund would need to increase its exposure by $30 in order to make sure that at the start of day 2 the exposure is still 3X, as desired.

 

Leveraged ETF vs Futures

The example below, will compare the performance of a 3X ETF vs a future contract to see how the daily rebalance to keep the leverage ratio fixed in the ETF will generate a difference in performance that, each day, is equal to 6 times the product of the 2 most recent consecutive returns (as seen in the table above).

Let’s assume we have 1 micro-future on NASDAQ. At a price of 14,000, this contract would have a notional exposure of $28,000. If we want to have the same initial notional exposure via a 3X ETF, we can buy $9,333 of this product.

As the market moves, each product will generate a P&L and while they are the same on the first day, they will start to differ over time. The amount (and sign) of the difference will depend on the sequence of positive/negative returns we see over time.

The examples below shows how a trending sequence of return will generate higher returns for the 3X ETF, while a sideways market will penalise the 3X ETF vs the future.

As we saw earlier, the fact that consecutive returns have the same sign (i.e. the market is trending in one direction) help the 3X ETF to out-perform the future. The opposite is true when markets frequently flip sign.

 

The role of volatility and strategy performance

In this context, volatile markets are directionless and experiencing frequent swings that keep eroding the performance of the instrument.

We can expect that a strategy like Trading Mate that tries to increase exposure to the markets only when a directional move is expected, will not suffer much from volatility drags.

Let’s see below how Trading Mate’s strategy would have performed by using the following 3X ETFs: UPRO, TQQQ, UDOW and TNA.

In the charts below the “market” (red line) is a buy & hold investment in that specific 3X ETF, while the strategy returns are shown in blue. 

While in all cases, the risk-adjusted performance of the strategy is higher than a simple buy & hold of the instrument, it is also interesting to note how TQQQ and TNA’s different behaviour has not impacted much on our strategy performance: in both case we have a 50%+ annualised performance, less than half the VaR and Expected Shortfall and a lower drawdown profile compared to a buy & hold.

 

A focus on 2020/21

In a long-term chart it is never easy to clearly see the 2020 performance so this section will show the performance, risk metrics and drawdowns since Jan 2020 by using 3X ETFs to follow Trading Mate’s strategy.

Again, in the charts below the “market” is a buy & hold investment in that specific 3X ETF.

If interested in current Trading Mate’s exposures, please click on the link below.

Access the updated portfolio here