When the markets are flat but volatile.<\/p>\n
It’s a Sunday night and Jill believes the markets will swing upwards tomorrow. She buys her daily 3x leveraged bull ETF on Monday morning for $100. On the first day the benchmark index declines by 5% to 95 and Jill’s ETF declines by 15% to $85. Her exposure to the market is now $255. On Tuesday the index swings back up to 100 gaining 5.26 percent. Jill’s ETF returns three times this 15.78% and rises to $98.42 cents for a total exposure of $295.26 cents.<\/p>\n
On Wednesday the benchmark index continues its rally and rises to 105 points for a 5 percent gain. Jill’s ETF rises to $113.18 cents with a total exposure of $339.54 cents. Thursday sees the benchmark index erasing its gains and dropping back to 100 points for a 4.76 percent decline. Jill’s ETF drops 14.29 percent to $97.02 cents and $291.06 cents worth of exposure. On Friday the benchmark index declines 5 percent to 95 and Jill’s ETF drops 15 percent to $82.46 cents or $247.38 cents of exposure. Finally, on the following Monday the index rises back to 100 points gaining 5.26 percent and Jill’s ETF rises 15.79 percent to $95.48 cents with $286.44 cents of exposure.<\/p>\n
This type of whipsawing environment can have a significant impact on leveraged ETFs because daily leveraged ETFs respond to gains by increasing exposure and respond to losses by decreasing exposure. So each day’s market movement changes Jill’s exposure level.<\/p>\n
In an environment where the index value moves up and down each day starting at 100 and ending at 100 Jill’s daily 3x leveraged bull ETF ended up losing 4.52 percent due to negative compounding.<\/p>\n
To summarize, if an investor like Jill holds a leveraged bull ETF for longer than a day her returns may be significantly higher or lower than a cumulative return of the index times 3, because of the way compounding changes one\u2019s exposure to the market from day to day.<\/p>\n
In the first example with a steadily rising market Jill’s returns were significantly higher than 3 times the index\u2019s cumulative returns. In the second example her losses were significantly less than 3 times the index\u2019s cumulative loss. In the third, and final example, even though the index ended 6 volatile days with no change, Jill ended up losing money on her investment.<\/p>\n
It’s important to understand that in all three scenarios Jill’s ETF did exactly what it was designed to do on a daily basis. However, as the fund performed its daily rebalances over extended periods of time, positive or negative compounding occurred, and the returns ended up differing sometimes quite significantly from the cumulative return of the benchmark index multiplied by 3.<\/p>\n