Meet The Worst ETPs In The World: Leveraged ETNs
Updated: Oct 22, 2019
Without a doubt, ETFs have been among the most popular products among investors in recent years. As mutual funds are struggling more and more to justify their fees, asset inflow into ETFs has consistently been increasing. But while some ordinary ETFs can indeed generate satisfying results for retail investors, other, more sophisticated products hit the market: Leveraged ETNs. Whereas ordinary ETFs aim to track the performance of their underlying, leveraged ETNs are supposed to either provide the leveraged or the inverse leveraged return of the underlying. The amount of leverage used is quite substantial at times, with some ETNs aiming to provide 4 times the performance of the index they are supposed to track. But as usual, whenever banks start to structure products with immense amounts of leverage, the smartest thing you can do as run away as far as you can.
Performance of leveraged ETNs
In order to see what is meant by “run as fast as you can”, the only thing one must do is look at the leveraged ETNs performance. The chart above displays one of the most prominent examples: 3x leveraged ETNs on the junior gold mining index. The index (grey line) is, despite being very volatile, moving sideways most of the time and ends the four year period roughly where it began. As both the leveraged long and the leveraged short ETN aim to provide 3 times the return of the index, one might assume that they should not have moved much either, given the performance of their underlying. That would be very much a wrong assumption, however: As the chart displays, BOTH the long and the short leveraged ETN have lost almost ALL of their value and would most likely have already approached a share price of 0, if it wasn’t for several reverse stock splits.
This massive drop was not triggered by some malfunction of the ETN, but was much rather expected to happen. In fact, even the sales prospectus itself states that such a loss can occur over the long term. The table below is a screenshot from the prospectus offered by Direxion (the issuer of the ETNs) and demonstrates how index return and volatility can impact the performance of a 3x leveraged long ETN (performance for the inverse ETN is exactly the other way round).
While it should not come as a surprise that a negative index return can have a negative impact on the performance of a leveraged ETN, it might be interesting to see that even if the underlying boasts massive double digit returns, the ETN can still end up losing almost all of its value. As the chart clearly shows, the volatility of the underlying can have a massive impact on the performance of the ETN. Between 2014 and 2017, the junior gold miners index had an annualized volatility of 50.72%, which should already hint at the negative performance of the ETN, as at this volatility level, the index would need to gain almost 30% just to have an overall positive performance. In order to see in more detail how the combination of volatility and leverage can drag down the overall performance of an ETN, it is important to take a look at the negative compounding effect.
The negative compounding effect
In order to demonstrate these effects, a hypothetical index is created that, over the course of 5 trading days, fluctuates a lot, but eventually returns to its starting value. The daily returns of this index are then multiplied by three and then used as (inverse) daily return rates for a hypothetical ETN that wants to provide an investor with the 3x (inverse) return of the index. As this example shows, BOTH the long and the short ETN lose some of their value. Even though this is quite an extreme example (the annualized volatility of this underlying would be roughly 86%), it shows how negative compounding can influence the performance of leveraged financial products. With that in mind, does this imply that one should just short all the leveraged volatility ETNs available?
Quite frankly, the answer is no! The reason for that is that this effect can also work the other way round. The table above shows what can happen if the underlying moves in the same direction for 5 consecutive trading days. Even though the underlying only gained 15%, the underlying went up 50%, which is more than just the 3-fold return of the index. The inverse ETN, on the other hand, only lost 36% of its value over the same period. This means that shorting both ETNs on day 1 would have resulted in quite a substantial loss. Once again, it is not very likely that an index rises by such massive amounts in such a short period of time, but it should demonstrate that shorting leveraged ETNs is not free money.
How to trade leveraged ETNs
Taking all this into consideration, two things should be obvious: One, buying a leveraged ETN for any other purpose than short time speculation is not a very appealing trade. Two, just shorting all the leveraged ETNs available and expecting to retire on your own private island within a few years’ time does not work either, because the very same effect that can just as well work against a trader. Moreover, another thing that investors face, once they want to implement a trade are shorting fees. While shorting fees for liquid shares, such as Apple, are usually not even needed to be considered, they can be quite substantial for leveraged ETNs. Depending on the liquidity of the ETN, shorting fees range from 4% p.a. to 16% p.a. and can therefore have a quite substantial impact on the overall return. This should by no means however imply that leveraged ETNs cannot be traded effectively and positive returns can be achieved when the trades are conducted correctly. In another article that will be published this month, I will supply my take on how leveraged ETNs can be traded effectively and what has to be kept in mind before shorting leveraged ETNs.
Also published on Seeking Alpha: https://seekingalpha.com/article/4296423-meet-worst-etfs-world-leveraged-etns