AH! Leveraged ETFs, bearer of infinite deliberations, good or bad, useful tools or weapons of mass destruction.
Tradr launched 2x leveraged funds that target weekly and monthly returns instead of the typical daily performance, with quarterly funds coming in October. Good news?
Daily reset
All the single underlying instruments (i.e. the non-capital efficient types, like NTSX or RSSB) leveraged ETFs that were on the market before Tradr had a daily reset, meaning they were matching, with leverage, the daily performance of their target. On any single day, the 3x S&P500 ETF returns the same of the S&P500 x3 (less costs). They are great instruments for intraday traders, lads that use them as originally intended: holding them for a single day.
There’s no investing-police preventing market participants to hold these ETFs longer than a day. Here is the issue: the longer an investor stays, the higher the chance the ETF performance would diverge from the target “Underlying performance times leverage”.
Why? Let’s say I buy today $100 of UPRO, the 3x S&P500 ETF. In my mind, my exposure is equal to $300 in SPY. After one day, SPY is up 10% and my holding is now worth $130. The next morning, UPRO resets its leverage, i.e. uses $130 to buy the equivalent of 3x SPY. If on the second day SPY is up another 10%, my holding is worth $169: I gained $69 while the unlevered SPY gained $21. The effect of the daily reset is that I have a $69 profit instead of the “expected” $21*3=$63.
In order to achieve my expected return, I would have sold part of UPRO at the end of day 1. If I had bought SPY, end of day 1 I would have had $110, therefore I should have sold $20 of UPRO to achieve my goal.
Volatility Drag
The consequences of the daily reset are somehow confused with the volatility drag.
The volatility drag is simply that if an investment does +10% one day and -10% the next, the average return is 0% but the real return is -1%. I assume if you ended up reading this post you know why after losing 10% you need more than 10% to get even.
What is usually lost in the volatility drag discussion is that it affects any investment, not just the leveraged ones. SPY returns have volatility drag. Its CAGR is different from its arithmetic return.
Leverage amplifies the effect of volatility drag because the levered return’s volatility is higher. But if the investor rebalances their holding every day, they can obtain their target return (less management fee and transaction costs).
The more volatile the underlying asset, the higher the effect that leverage has on the final return (without the daily rebalancing). The most used example these days is the 3x Microstrategy ETF:
The unlevered stock is up 66% and the levered investor lost everything.
Is daily reset an issue?
If you never rebalance, yes:
These are the 5-year rolling windows for SPY, SSO (2x SPY) and UPRO (3x SPY). There are plenty of instances where UPRO didn’t achieve 3x of SPY.
On a yearly basis, the picture is better (sry had to use PortfolioVisualizer so…only 10 years of data):
‘Just’ 2015 and 2020 didn’t deliver.
With a quarterly rebalance we get almost there:
Let’s not forget that SSO and UPRO have higher management fees compared to SPY and their cost of funding is higher than the return of CASHX.
If you use legacy leveraged ETFs in a portfolio and you rebalance regularly, I guess there is no issue?
The new reset ETFs
When I read the news about the launch I was happy. Then I looked at the management fee and…I was not happy. 1.30% compared to 0.92% for the ProShares products? That’s an absolute no for me.
The beauty of these new ETFs is that, if you rebalance when they rebalance, ideally once a quarter when the quarter-rebalancing will be launched in October, you are perfectly in sync with the return you are targeting.
But I do not think the additional 40bps in costs justify the move. In fact, the daily-reset ETFs do their job fine enough. Another (semi) crucial aspect of these new ETFs is that you have to start buying exactly on their rebalance day if you want to achieve the target leverage; any other day, you might be off. Sure, you can figure out the ETF performance from the rebalancing day to today and size your trade accordingly, but still, you have to pay attention, especially for the quarterly one.
Tradr made the right decision…until it came to the pricing part. Sadly, a missed opportunity.
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