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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.


    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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  • 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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