Leveraged ETFs are designed to return double or triple the return of an index each day, but they come with disclaimers warning that they won’t double or triple returns over longer periods of time due to a mysterious compounding effect. I’ve come up with a more concrete explanation that is hopefully more understandable.
An example of a leveraged ETF is the Horizons BetaPro S&P/TSX 60 Bull ETF (ticker: HXU). If the TSX 60 goes up 1% on a given day, HXU goes up 2%. The confusing part is that if the TSX 60 goes up 10% in a year, HXU doesn’t go up 20% that year.
A partial reason is the management fees charged to run HXD, but this doesn’t fully explain the seemingly missing returns. To understand what is going on, imagine a volatile 2 days where the TSX 60 goes up 10% then goes down 10%. Let’s track a $100 investment in the TSX 60 for the 2 days:
TSX 60: Start: $100, after up day: $110, after down day: $99
So, by the magic of compounding we lost a dollar. Here is the unsatisfying explanation of why things are worse than expected for our $100 investment in HXU:
HXU: Start: $100, after up day: $120, after down day: $96
For some reason we’ve lost $4. But it seems like we should only have lost $2 because HXU is designed to double the TSX 60 return. Just imagine what it would be like for a 10x leveraged ETF: our money doubles the first day and then we lose it all the second day!
To understand why the HXU losses are larger than we expected, let’s look in more detail at the holdings of HXU. To double the return of the TSX 60 with a $100 investment, HXU would have to borrow $100 so that it can hold $200 worth of TSX 60.
After the up day, HXU would hold $220 worth of TSX 60 and after accounting for the borrowed $100, we have $120 net. However, we’re supposed to be leveraged 2:1. HXU has to borrow another $20 to buy more TSX 60 so that it holds $240 worth of TSX 60 and owes $120.
After the down day, the TSX 60 investment drops by $24 to $216. HXU owes $120 leaving a new net value of $96. To get back to 2:1 leverage, HXU must sell $24 worth of TSX 60 and repay part of the loan leaving it with $192 of TSX 60 and a loan of $96.
After each up day, HXU must buy stock and after each down day it must sell stock. If this sounds like a buy high and sell low strategy, you’re right. The actual mechanism leveraged ETFs use to get exposure to an index may be more complex and make use of derivatives, but this doesn’t change the fundamental problem of buying high and selling low. Note that this explanation didn’t involve MERs, trading costs, or borrowing costs. These things only add to the drag on returns.
Of course, the TSX 60 doesn’t usually swing up and down by 10% each day. So the losses due to volatility are smaller than this example each day, but they add up over the course of a year. Over a long period of time, the HXU return will be significantly less than double the TSX 60 return.