ETFs continue to grow in market share as investment vehicles, increasing some $372bn in 2015, 10% more than in 2014. Based on this and other reasons, Xtrade added ETFs to its Assets Portfolio in October. Also, the record growth reflected in the 43 industry entrants last year.
Among the key reasons for the increased interest are dissatisfaction with high fees in the traditional fund market. Along with swelling investor appreciation of active managers’ inability to beat their benchmarks. More than just financial instruments.
ETFs are a veritable ideology that will continue to reshape asset management. Yet, do you know how to calculate Leveraged ETFs compound returns?
Among the more profound options introduced by the industry are leveraged and inverse ETFs. These allow investors to magnify the returns on an investment. However, understanding the mechanics and larger picture is necessary to make the most of these specialized professional tools.
Particularly those using these as hedge tools must fully master the details and rebalance their holdings to ensure desired results.
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The Art of Understanding Leveraged ETFs
Before we take a look at how to calculate Leveraged ETFs compound returns, let's get a better understanding of trading ETFs. Apart from the generic investment issues like: commissions, execution platform, taxes, buy/sell spreads and liquidity,- leveraged ETFs require a trader to understand the expected holding period price variance.
While a “2X” multiple appears desirable when you expect a movement in that direction. A leveraged ETF will require a non-varying return over the entire period to actually generate such a return, as interim (usually daily) portfolio rebalancing affects the outcome.
Returns over periods other than one day will likely differ in amount and maybe even direction from the target return for the same period. The chart above displays the potential under performance in a mean-reverting market for leveraged bull ETFs.
It is drawn over roughly an one-month period. Alongside, you also find the chart for the inverse ETFs, which were also drawn over the 1 month period. The effects on the returns may be more noticeable in ETFs with larger or inverse multiples and in funds with volatile benchmarks.
Because of the daily leverage reset, in choppy markets, returns will vary dramatically. Traders must continuously monitor their holdings consistent with their strategies, as frequently as daily.
How to calculate Leveraged ETFs compound returns?
The math of compounding returns is not rocket science, but nevertheless must be mastered. The following example should illustrate this issue. An one-day non-directional leveraged two-fold minus ETF with exposure to the Dow Jones Industrial Average. Every day, the fund generates a return, either plus or minus, and it re-balances its exposure to ensure a constant multiple to a fluctuating asset base. Here’s a hypothetical example, helpfully noted by ETF.com:
At purchase on day 1, the double-minus-return fund is at 100. On day 2, the Dow-Jones index goes up some 10 percent to 110, and the fund falls 20 percent to 80: Straight one period return. But on day 3, the Dow Jones loses 10 percent: 10 percent of 110 is 11, so the index declines from 110 to 99. Twenty percent of 80 is 16, so the fund rises from 80 to 96.
So we see here a fund delivering on its two-fold minus daily returns (and losing one percent in value in the process), but the trader has lost 4% in the fluctuation.
These variances from stated exposure may be of lesser consequence to the individual trader (speculator) over a short term position, but if you are hedging portfolio currency exposure through ETFs, you must constantly monitor and re-balance — typically at either dollar or volatility triggers or specified time intervals.
To be clear, if you’re making a short-term bet on something—speculating, in other words—you may not care about achieving the precise multiple.
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The tips on how to calculate Leveraged ETFs compound returns, was provided by Xtrade. Xtrade is an award-winning brokerage that offers CFD trading on stocks, indices, commodities, and currencies. Its cutting-edge technology, available on both desktop and mobile devices, includes five digital trading platforms. These are accessible to traders across Europe, Asia, and Australia in over 40 languages. The company also offer a sophisticated trading education centre, real-time financial news, and innovative trading tools. Xtrade’s Global Ambassador is Cristiano Ronaldo of Real Madrid, who features on the company’s digital hub. Xtrade possesses over a CySEC license, in accordance with the EU’s Markets in Financial Instruments Directive. But also holds the Australian Securities and Investment Commission, and South Africa’s Financial Services Board licenses.
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