In today’s uncertain market, investors are looking for a wider variety of tools to help them capture returns and protect their investment capital. One of the most powerful (and sometimes dangerous) tools is the leveraged ETF. These investment vehicles have been trading for a few years and have become very popular both with daytraders and investment managers looking for ways to hedge their exposure.
A leveraged ETF is designed to trade at twice (or three times) the velocity of an underlying index. So if the Russell 2,000 were to trade 3% higher today, the Daily Small Cap Bull 3x Shares (TNA) should rally by a full 9%. In contrast, the leveraged 3x short vehicle (TZA) should trade down by 9%. The inverse funds can be very helpful in helping long-only managers to offset their daily risk as a small position in the 3x bear funds can capture significant gains on a negative day which will offset that managers portfolio losses.
But leveraged vehicles have gotten a lot of bad press lately because of a mathematical property I call volatility decay. Now to be clear, this is not an error in the design of the funds, it is simply a mathematical property that many do not take into account when using these tools. The tools work exactly the way they were designed to – it’s the investors who need to understand how to use the tools.
Let’s take a volatile week and see how a triple index fund would perform:
- Monday: Down 5%
- Tuesday: Up 3%
- Wednesday: Down 4%
- Thursday: Up 6%
- Friday: Down 2%
Using the returns for the index, you would end up with a 2.42% loss. So if you were using a triple leveraged inverse fund, you might expect your gains to be 7.26%. However, the math doesn’t quite work that way. Here is how a $10,000 position would likely trade if the fund perfectly tracked the market:
- Monday: Up 15% – now holding $11,500
- Tuesday: Down 9% – now holding $10,465
- Wednesday: Up 12% – now holding $11,721
- Thursday: Down 18% – now holding $9,611
- Friday: Up 6% – now holding $10,188
So you see, in a volatile period, the investment would only have returned 1.88% despite the fact that the market was down 2.42% and your investment was supposed to return three times the opposite of the index. That’s because each day the funds reset to offer 3x exposure the next day. This daily reset works to our favor in a steadily trending environment (assuming the trader picks the right direction), but works against us in a highly volatile market.
But don’t give up on the idea of using a leveraged investment to help protect your capital (or supercharge your returns). Direxion Funds has developed a series of mutual funds which are designed to help avoid the volatility decay associated with the daily volatility. These mutual funds are instead geared to return double the monthly performance of the index they track. So with these funds, if you buy on December 31, you can expect that on January 31, you will receive 200% of the price movement of the underlying index. The funds do not reset daily and so you don’t have the negative (or positive) compounding effect on a daily basis. There is still a volatility decay property to the funds, but it occurs on a monthly basis rather than a daily basis. This is much easier to manage and makes the mutual funds a bit more relevant to long-term investors.
One thing to consider is that if you buy a fund in the middle of the month, you may be getting higher or lower exposure to the market through the end of the month. This is because the funds do not reset mid-month to account for the price movement that the market has already undertaken. But Direxion has a good solution for this potential problem. If you click on this link you can see the “estimated current exposure level” which can serve as a guide for how much of a particular fund you should buy to meet your hedging or speculation target. Mutual funds offer the benefit of more accurately offsetting your losses over a longer period, or making a directional call on the market for a wider time frame. However, the drawback is that the funds are traded on a daily basis, so you can’t liquidate your position at any point throughout the day. But don’t worry, there are plenty of leveraged ETFs to help offset your mutual fund exposure throughout the day!
FD: Author does not have a position in any stocks mentioned in this article.
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