Leveraged ETF Lesson

But how do they do that?  A slight change in the language of the type of leverage offered by the ETF makes all the difference in the world.  Look closely at what the ETF says when it comes to the payoff profile of the leveraged ETF. Here are the specifics of the NUGT and DUST 3X bull and bear Daily Gold Miners leveraged ETFs:

(Click on image to enlarge)

Look closely at the first line of the second paragraph:

"These leveraged ETFs seek a return that is 300% or -300% of the return of their benchmark for a single day."

In our previously discussed traditional leveraged case, if an investor meets margin calls, then a 3 times return (minus borrow costs) is assured regardless of the time period.

However, the leveraged ETF is not offering that payoff profile.  The leveraged ETF's return will be a series of 3 times returns for each day.  I know that doesn't sound that different, but it's night and day.

To best illustrate this difference, let's engage in a mental exercise of pretending we are the ETF administrator in charge of offering this 3 times daily return.  Bear with me as we do a little math.  At the end of this process, I think it will be more clear about what is happening with the leveraged ETF.

Let's use our original ETF example of $100 million of equity controlling $300 million of assets.  Sometimes the best way to understand something is to use dramatic price changes and walk through what happens.

If the underlying asset price moves up 20% in a single day, the total value of the assets is now $360 million.  Assuming the ETF starts at a price of $100 per share, it's now worth $160 ($360 MM - $200 MM borrowed = $160 MM).

However, what happens if it moves up another 20% the next day?

If the ETF administrator makes no changes, then the $360 million of assets rises to $432 million.  That means the ETF is worth $232 ($432 MM - $200 MM borrowed = $232 MM).  

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Disclosure: None.

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