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  • Leveraged ETFs: Why the Bear decays more than the Bull in a flat market

    Posted on June 3rd, 2009 Peter Tjernström No comments

    In a previous post I have shown how the market volatility destroys the value of your leveraged ETF over time due to the fact that the funds are rebalanced daily in order to maintain a constant leverage.

    So, if the market trend is flat, the ETFs will lose value due to the inter (not intra) -daily movements around a certain index value. But if the index returns to the value X after one month of ups and downs, the loss in a Bull and Bear ETF would be the same, right?

    This is maybe the intuitive answer, but the fact is that the Bear will be much more hurt than the Bull in that example. The reason for this is quite simple, while the sum of index points variations is zero (the index is back at the starting value), the sum of the percentage loss with leverage is not equal to (it is smaller than) the sum of the percentage gain with leverage.

    Illustrated with an exemple: If the index gains 5% the first day to take it to 105 points, it needs to lose only 1-(100/105)=4,7619% on the next day in order to return to 100. Since a Bull ETF with 1,5 leverage gains 1,5*5%=7,5% on the first day and loses 1,5*4,7619%=7,1420% on the second day, while the reverse is true for the Bear, they start to divergate to the disadvantage of the Bear. This is illustrated in the graph below.

    click to enlarge

    click to enlarge

    Conclusion: the reasons to be careful with keeping Bear funds too long go beyond that of loss due to volatility. They have a built-in mechanism to make them lose compared to Bulls even in a completely flat market trend.

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    Side note: the leveraged ETF topic has caught a lot of attention lately, but explainations in traditional business media are often messy, like this one (Swedish).

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