Leveraged ETF Lesson

But let's remember back to what the ETF was promising.  It's supposed to be 20% of the daily return each day.

In our example, if you bought it at the end of the first day ($160 close) and sold it at the end of the second ($232 close), would you achieve this 20% x 3 daily return?

[ $232 - $160 ] / $160 = 45%

Whoa!

That makes no sense, right?  Well, I have made the moves unrealistic so that you can see what's going on, but this happens on every single leveraged ETF.

The ETF provider needs to ensure a leveraged return on the asset for tomorrow's move, not for the original investment.  So at the end of each day, they need to readjust.  

In our example, the ETF was priced at $160 with $360 million in assets.  But to get a three times leveraged return the next day, the ETF needs to have $160 * 3 = $480 MM in assets.  

Therefore the ETF needs to BUY $120 MM of assets on the close of the first day (which it borrows, making total borrowing $200MM + $120MM = $320 MM).

Now, let's go through the numbers and see what happens from there.

The ETF has $480MM of assets which rise another 20% the next day.

After that rally, the numbers are as follows: $480 MM * 1.2 = $576 MM.  The price of the ETF would be $576MM - $320MM = $256 MM = 256 per share.

Let's review; 160 with a 20% rise x 3 = 160 * 1.6 = 256 per share.

So what does this mean?  The ETF administrator needs to BUY MORE EXPOSURE EVERY NIGHT AT THE CLOSE WHEN THE ASSET IS UP IN PRICE, and SELL MORE EXPOSURE EVERY NIGHT AT THE CLOSE WHEN THE ASSET IS DOWN!

Now let's think about that.  The ETF buys as it goes higher, and sells when it goes lower.  What happens in our example if the asset price falls the next day by 30.55%?

Well, let's just confirm what the underlying asset return would be:

Day 1: 100
Day 2: after 20% rally = 120
Day 3: after another 20% rally = 144
Day 4: after 30.55% sell off = 100

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Disclosure: None.

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