Monday, 17 June 2013

Leveraged Exchange Traded Funds: a trader's tool

Among the ever growing family of exchange traded funds (ETF's), there are quite a few leveraged products. Direxion probably is the larger distributor of this particular type of ETF's.

They do come with a warning:
( …) Leveraged ETFs are short-term trading vehicles that seek returns that are 300% (or -300% in the case of the Bear Funds) of the return of their benchmark index for a single day. The pursuit of a daily leveraged investment goals means that the return of the Funds for a period longer than a single day will be the product of the series of daily leveraged returns for each day during the relevant period. The funds should not be expected to provide three times the return of their benchmark’s cumulative return for periods greater than a day.
(for the full text see page concerned.)

The warning isn't there without reason: since they are designed as a trader's tool rather than an investment vehicle, it is a mathematical certainty that these products will underperform the benchmark cumulative return over the longer haul.

Precious metal mining is one of the main subjects of this blog. GDM is the underlying index for both NUGT and DUST. A simulation experiment on these 3x leveraged gold mining plays NUGT (bullish) and DUST (bearish) should convince you and illustrate what I have in mind:

Experiment day 1: GDM plunges 10%, from 100 to 90. (OK this is exceptional, yet 5% daily moves and slides became rather common).
Repercussions:
  • NUGT plunges 30%, a $1000 trading position turns to $700.
  • DUST rallies 30%, a $1000 trading position turns to $1300.
Experiment day 2: GDM rallies from 90 back to 100. Observe that this implies a 11.11% rally.
Repercussions:
  • Now NUGT rallies by a third (33.33%), great. Yet that only brings your trading position back to: $700 x (100% + 33.33%) = $933.33.
  • DUST plunges by a third (3 x 11.11%). Not only yesterday's gain evaporates, but so does part of your initial trading position: you are down to $1300 x (100% - 33.33%) = $866.67
Slides and rallies nearly always are more gradual. The loss of a leveraged ETF over a 10% swoon/rally cycle, bringing the underlying index back to its initial level should not be as high as what is illustrated before.

Yet, over the long haul, the slide of GDM ranges around 60% since its top. It's hardly surprising that NUGT, the bullish leveraged ETF, went through a 5:1 reverse split and still quotes considerably below DUST.  NUGT accumulated a loss of about 90%. The 10% of your investment you've got left might quadruple if GDM were to rally 100% over night (in your dreams...) and you still would face a stiff 60% loss.

Beware that a trader's tool is not a suitable investment vehicle.

A must read: 7 mistakes to avoid when trading leveraged ETFs

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