Leveraged ETFs often advertise their volatility versus a tracked index with the multiple included in the name of the fund. For example, an investor who buys the Direxion S&P 500 Bull 3x ETF (NYSEARCA: SPXL) assumes that the fund triples the volatility of that index. What is not mentioned in the title is a second element that is part of all leveraged funds, referred to as “rebalancing,” that can compound volatility whether the underlying index is increasing or decreasing.

The Structure of Leveraged ETFs

Leveraged ETF structures vary between funds and their objectives. For example, a fund that provides 3x long exposure might be composed of an equity position combined with cash, long futures and other derivatives, such as swaps. Inverse funds, which are structured to deliver leveraged returns on declining prices, are likely composed of short futures contracts, cash and swaps. When these elements are rebalanced, the result can be either positive or negative compounding.

How Positive Compounding Works

Leveraged ETFs are rebalanced after the market close each day to bring them in line with their stated objective for the following trading day. For example, if an investor buys 1,000 shares of a 3x ETF at $10 per share, the leverage increases the exposure to the underlying index to $30,000, or three times the $10,000 cost of the shares.

If the index closed the next day with a gain of 5%, the shares gain 15%, or three times the 5% gain, increasing the ETF's share price to $11.50 per share. To bring the fund’s stated leverage in line with the day’s closing price, the share structure is rebalanced to increase exposure to the index to $34,500, or three times the 1,000 shares times the $11.50 share price. The resulting increased exposure creates the opportunity for positive compounding if the price of the index appreciates the following trading day.

Negative Compounding at Work

Rebalancing also takes place when the underlying index for a leveraged ETF declines. Downward rebalancing tends to exacerbate losses and can diminish a leveraged ETF’s performance, even when the direction of the index has a general correlation with the fund's objective.

Using the $11.50 per share ETF described above, an index loss of 5% on the following day reduces the share price by $1.72 to bring the share price down to $9.78. In addition to generating a larger loss than the previous day’s gain, rebalancing the shares also reduces the exposure to the index to $29.34, or three times the $9.78 share price.

Negative compounding would gain speed if the underlying index were to lose another 5% on the following day. This loss would drop the share price to $8.32 per share, for a cumulative loss of 16.8% versus a net loss on the index of 5.2%. Subtracting only the 5.2% loss at 3x leverage, the loss on the ETF is 15.6%, but the negative compounding due to rebalancing increases the loss by an additional 1.2% over only two days.

The Takeaway

The rebalancing involved in leveraged ETFs can result in either positive or negative compounding. For investors, the challenge is that the true power of positive compounding is only exhibited on uninterrupted moves that correlate with fund objectives. When markets move erratically, the negative compounding that occurs on days when downward rebalancing takes place can diminish overall performance.

However, the biggest threat for investors comes when positions held as an index make a sustained move against a leveraged ETF. In those situations, negative compounding can magnify accelerating losses resulting from the leverage built into the fund.

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