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  • How volatility deteriorates your leveraged ETF (e.g. XACT Bull) over time

    Posted on April 8th, 2009 Peter Tjernström 3 comments

    This article will describe why market volatility will make leveraged exchange traded funds (ETFs) lose value compared to the underlying asset and why these funds are unsuited for long term holding.

    During the last 7 months or so, ever since the fall of Bear Stearns, the world has experienced very volatile asset markets. On the stock markets world wide, the long term trend has clearly been down for some time. One way to exploit market downward trends is to use an EFT with short, i.e. negative, leverage. XACT Bear and XACT Bull, with 50% negative and 50% positive leverage respectively, are the by far most popular ETFs in Sweden. Across the world there are of course similar products. All have in common that they are exchange traded and offer leverage against and underlying value, often a stock index.

    In order to make sure that the leverage is maintained daily, the funds are doing a daily rebalancing of their derivatives such as index futures or swaps. The short explanation to way these funds will lose on volatility is: in order to maintain a constant leverage, they are forced to buy at higher prices and sell at lower.

    To deal with this in a more systematic way: please have a look at the graph below. You can clearly see that in a volatile market, the leveraged ETFs will be outperformed by the underlying index after some periods of ups and downs.


    After 9 days of alternating 5% increase and 5% decrease, the index is at 97,8 points whereas the funds with 50% leverage are at 95 points (independent of leverage direction). Note also that the fund with 100% leverage loses more that twice as much and ends up at 91,4 points. Without going into the maths, this shows clearly that the percentage loss as a function of leverage is a steeper-than-linear one.

    Now let us look at an example from reality. The graph below shows XACT Bull (blue line) and its underlying index OMX30 (red line) from October 21, 2008 to January 12, 2009. I have deliberately adjusted the dates so that OMX30 is at the reference value (“80”) on both of these dates. As you can see in the graph, XACT Bull is at 77.5 and thus has lost more than 3% of its value in less than 3 months. No dividend was paid out by the fund during this period of time.


    In summary, it obvious that while leveraged ETFs are good for hedging and short term speculation, they are not suitable for long term holding.

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    3 responses to “How volatility deteriorates your leveraged ETF (e.g. XACT Bull) over time”

    1. Bra artikel.

      Men loose och looses stavas bara med ett o.

    2. Tack! Och stavfelet är ändrat.

    3. Yet another explanation of leveraged decay: