This lesson explores short and leveraged (S&L) ETPs and what investors should be aware of when investing in these products – for example, daily returns and compounding.
Investing in Short & Leveraged ETPs
Exchange traded products (ETPs) were initially seen as a way of gaining passive long exposure to key equity benchmarks, but these products now offer exposure to increasingly exotic and diverse underlyings.
Short and leveraged (S&L) ETPs are particularly popular. That’s because in the absence of ETPs, acquiring short and leveraged exposure can be complicated and difficult to access. It may involve direct borrowing, margin management and option trading.
S&L ETPs helped simplify these complexities.
They provide short, leveraged short, and leveraged long exposure to underlying benchmarks, but retain the accessibility and tradability of ordinary shares. Also, the indices underpinning S&L ETPs have transparent, publicly available pricing methodologies.
How S&L ETPs Work
In contrast to long ETPs, short ETPs rise in value when an underlying benchmark declines, so they can be used to profit from, or protect against, downward price movements.
Leveraged ETPs magnify exposure to an underlying index and can be applied to both long and short positions.
They enable investors to gain a greater degree of exposure with less upfront capital, allowing them to express high conviction investment views or to implement capital efficient hedging strategies.
The exposure of S&L ETPs to an underlying benchmark’s performance is multiplied by a given multiple known as its ‘leverage factor’.
The time period that is defined, usually daily, is very important, because the leverage factor is applied to the benchmark performance over this period and then reset.
An investor invests in a 3-times (3x) leveraged short ETP for three days.
On day one, if the index falls 2% over the day to 98, then with a short leverage factor of 3, the value of the ETP will increase to 106, i.e. a 6% rise.
Because each new period requires the ETP’s performance to be based off a new base, in this example, a daily one, S&L ETPs can see their returns subject to a compounding effect.
So, if on the following day the index falls a further four points, which represents a 4.1% decrease from its previous value, then the value of the ETP will increase by 13 to a new value of 119, i.e. a rise of 12.3% from its previous value.
If, however, on the third day the underlying index goes up by 2.1% to 96, then the ETP investor will incur a loss of 6.3% for that specific period, and the ETP value will decrease from 119 to 111.4.
So, overall, by the end of day three, the value of the ETP is increased by 11.4%, even though the index has declined by 4%. Hence, the three-day performance of the index should not simply be multiplied by -3 as a means of estimating the 3x leveraged short ETP return.
Due to the potential for market volatility, S&L ETPs should be actively monitored.
Generally, if volatility is low, and the market is trending in favor of the investor, then compounding will increase the price of the S&L ETP. Conversely, a volatile market with daily gains and losses, will generally result in the S&L ETP underperforming.
In summary, S&L ETPs offer a suite of investment strategies that span all asset classes, allowing investors to express tactical views and hedge risks while preserving capital.
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Disclosure: Leverage ETFs
Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products. Learn more about the risks here: https://gdcdyn.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleView?formdb=4155