Compounding and when Markets Rise

Compounding can occur in any investment, but its effects are particularly pronounced with daily leveraged ETFs.

Why is this so?

As discussed in the previous chapters these ETFs seek to maintain a daily exposure of three times to the underlying benchmark index and this three to one exposure ratio is reset or rebalanced every day. The daily rebalance is essential in order for the fund to achieve its daily goal but can significantly increase or decrease an investor's exposure to the underlying index if they hold their position for periods greater than one day. These changes in exposure level over time can mean that the investors return can be different and sometimes significantly different than three times the cumulative performance of the index.

For the purposes of this section on compounding we will focus exclusively on Jill's 3x leveraged bull ETF and how different market conditions affect her exposure over time. We'll be examining three different multi-day scenarios. When the market rises steadily, when the market declined steadily, when the market is flat but volatile. Keep in mind that all figures going forward are calculated before fees and expenses.

For these hypothetical examples the index value is 100 and the movements are set at 5 points per day which is a large daily move.

When markets rise steadily. It's Sunday night and Jill has strong conviction that markets will swing upward tomorrow. On Monday morning she buys $100 worth of a daily 3x leveraged bull ETF. Because of the funds 3x leverage Jill's total exposure to the index is actually $300. As it turns out, Jill is right and by the market close on Monday the index rises to 105 points, a 5 percent gain.

Jill's $300 index exposure rises 5% to $315 giving her a $15 or 15% gain on her $100 investment. Her daily 3x leveraged bull ETF is now worth $115 and after the rebalance her exposure to the index is $345. Although Jill's ETF's stated objective is to only provide daily leveraged results, she'll decide to hold on to her investment because she believes the index will move up again the next day. On Tuesday Jill's instincts are proven right again and the index moves up another 5 points from 105 to 110. They return of 4.76 percent. Jill's $115 position rises by 14.28 percent to $131.42.

The index’s total two-day gain at this point is 10 percent. The upward index move after the rebalancing has caused positive compounding and the cumulative return of the ETF is actually 31.4% or 1.4 percent more than the index’s cumulative gains times 3. So at the end of Tuesday Jill's ETF is worth $131.42 cents.

On Wednesday Jill continues to hold on to her daily 3x leveraged bull ETF. The market continues its rally and her ETF's benchmark index rises another 5 points to 115. At the end of Wednesday, the index has risen 15% on the week but the rebalancing followed by favorable index moves has caused positive compounding. Jill's three-day return is actually 49.35 percent greater than 300 percent of the 15 percent index move. Her ETF is now worth $149.35 cents.

Let's assume this pattern continues for the rest of the week. On Thursday the index rises five more points to 120. The index has now risen a total of 20%, but the return on Jill's ETF is now significantly greater than three times that 60 percent at 68.83 percent. On Friday the index again rises five points to 125 and Jill decides to close out her position. Her ETF is now worth $189.94 cents. S

o, while the index’s total gain for the week is an impressive 25 percent, Jill's daily 3x leveraged bull ETF has returned significantly more than three times that 75 percent. The daily rebalancing has increased her risk each day and the subsequent upward index movements have caused positive compounding. As a result, the funds accumulated week-long gain is actually 89.94 percent.

While this positive return is certainly fortuitous for Jill, she understands that with each day's gain her exposure to the index increases at an accelerated rate. In a short period of only five days Jill's exposure to the market has nearly doubled as compared to her original investment. This level of exposure represents a high market risk. If for any reason the markets should experience a downturn, Jill stands to lose substantially more from a percentage standpoint than she would have if the downturn took place on day one. As a savvy investor, Jill recognizes her increased exposure and risk. S

he knows that even if she believes the positive trend will continue, it's probably prudent to sell a portion of her position to reduce her exposure, perhaps an amount equal to her gains for the week. Constant exposure level monitoring is highly recommended for all users of leveraged and inverse ETFs.

To learn more about Direxion’s leveraged ETFs please visit www.DirexionInvestments.com.