Understanding how leveraging and rebalancing work

Category: Asia, Hong Kong, Japan
By Tariq Dennison*

L&I products only suitable for investors that solidly understand principles behind them

Leveraged and inverse (L&I) products generally refer to exchange-traded funds (ETFs) that are designed to move double, triple, or opposite the daily move of a selected benchmark on any given day, rather than tracking it 1:1. Similar daily exposure has long been available through index futures and options, but L&I products differ by rebalancing daily to maintain a constant daily multiple over time. Daily rebalancing causes L&I products to “decay” in a way many investors misunderstand, and makes them unsuitable for many long-term investors, even aggressive ones.

While L&I products are often used as an alternative to futures and options, I strongly believe L&I ETFs are only suitable for investors who clearly understand futures, options, and the time decay calculations of L&I rebalancing.

Leading the way

The first L&I ETFs were launched in the US market in 2006 with ProShares “Ultra”, “Short” and “UltraShort” ETFs providing 2x, -1x, and -2x the daily moves of the S&P 500 index. These three remain among the largest and most heavily-traded L&I ETFs in the world today. The US market remains by far the largest and most diverse ETF market in the world across traditional and L&I categories, so it is a natural base for understanding global trends in L&I products.

This list (Table 1) shows:

  • A hot sector, like gold mining, can rise to the top of performance and AUM rankings at times of high demand;
  • Expense ratios for top L&I ETFs are around 0.8 – 1%, similar to other L&Is globally, but very high compared to other index ETFs, and;
  • 52 week return of the 2x (SSO) is not -1 x the 52 week return of the -2x (SDS).

In Asia, Japan was the first and continues to be the biggest L&I ETF market. The first in Asia (launched in 2012) and largest leveraged ETF in the world is currently Nomura’s Next Funds Nikkei 225 Leveraged Index ETF (1570.T), followed by its double-inverse Nikkei 225 ETF (1357.T), with about US$3 billion and $1 billion in assets vs. $35 billion in Nomura’s core Nikkei 225 ETF (1321.T). Trading-wise, the L&I ETFs dominate with $20 billion and $3.4 billion in monthly volume compared with only $1.6 billion for the tracker (source: Japan Exchange Group (JPX)). Unlike the diverse US market, Japan’s L&I products (like Japan’s overall ETF market) mostly track Japanese indices, with only one pair tracking a foreign index: the Hang Seng China Enterprises Index with only about ($10 million) each in assets (source: JPX).

L&I ETFs first came to Greater China in 2014 with Yuanta’s Taiwan Top 50 -1x Bear (00632R.TW) and 2x Bull (00631L.TW) complimenting its core tracker ETF (0050.TW). Yuanta also has L&I ETFs tracking Mainland China’s CSI 300 index with almost $1 billion in assets in the 2x Bull (00637L.TW) vs. less than $10 million in the bearish version (00638R.TW, Source: Bloomberg).

Hong Kong has been relatively cautious, with the Securities & Futures Commission (SFC) limiting multiples to +2x and -1x and requiring that L&Is be named “Products” and not “ETFs”. Late in 2016, two Korean and two Chinese firms listed L&I products on the Hong Kong exchange tracking the Topix, S&P, Nasdaq, Kospi, and Nifty. So far none of these products track any Hong Kong, H-share or A-share indices (as do eight of the top ten Hong Kong Exchanges and Clearing Limited (HKEX) ETFs), which may explain why none of these L&I products have yet exceeded HK$50 million (US$6.5 million) in assets as of February 2017 (source: HKEX).

Chinese retail investors, whether from the Mainland, Hong Kong or overseas, have shown clear demand for leveraged and short trading exposure to Chinese stock indices through the volume of mini-sized futures contracts and warrants on Chinese stock indices. It will be worth watching whether L&I ETFs will meet new demand, drive demand away from these other products, or be deemed unnecessary.

How L&I ETFs compare

L&I exposure on major indices have been made available through futures, options, warrants, and even some closed-end mutual funds for decades now.

Equity index futures contracts have long been the simplest liquid way to leverage linear long or short index exposure. With less than 1 million yen (US$8,862) in a margin account, I can get approximately 10 million yen worth of long or short exposure to the Nikkei 225 index, and know exactly how much each point rises or falls in the index makes or loses in my account. Futures need to be rolled typically every three months, but have no “time decay”.

Options are another way to trade leveraged long or short positions, but by guaranteeing exposure to only one side of the market, the premium invested in options loses its value through “time decay” if time passes without the index moving.

A version of a warrant called “callable bull-bear contracts” or CBBC provides linear multiplied exposure similar to futures, but with a “knock out” that minimises the effect of “time decay”. The HKEX still lists hundreds of CBBCs, mostly on the Hang Seng Index and HKEX-listed single stocks (source: HKEX).

L&Is typically track indices or assets that have very liquid futures or ETFs, but there is another exchange-traded instrument that specialises in leveraging less liquid assets – the closed-end mutual fund. Closed-end funds differ from the other contracts and products listed here in that they raise money once, and may term-borrow a portion of the funds raised to provide leverage to equity holders. Leveraged closed-end funds are popular in the US and may become more popular in Asia as high-yield debt markets develop with an increasing demand for yield here.

Rebalancing issues

The primary difference, and danger, of L&I products is how they rebalance exposure daily, and how this rebalancing causes “time decay” similar to that seen in options contracts. One main reason L&I ETFs are rebalanced daily is to provide consistency; i.e. no matter when you buy them, you will be exposed to the stated multiple of the benchmark index’s return that day, and the same product will exist for years without expiring or needing to be rolled.

L&I ETFs must “buy high and sell low” repeatedly to maintain constant daily exposure, causing decay of leveraged ETFs over time as the index fluctuates. Table 2 is a simple two-step tree illustrating how this works for different multiples over two steps of up and down scenarios.

Simulated over 100 trading days, this can be seen as a decay of 8% or more in the value of a 2x bull ETF vs. an index with daily moves of +/-3% – see Chart 1.

On the plus side, if an asset trends in one direction rather than trading sideways, the rebalancing has the advantage of continuously increasing exposure in the winning direction or decreasing exposure in the losing direction.

Perhaps the simplest illustration the long-term effect of rebalancing in terms of decay and trend following is the simple chart of the 10+ year history of two of the original S&P 500 ETFs against their benchmark since their launch in 2006.

The best time to own the short ETF was during the short weeks surrounding the crashes in late 2008 and early 2009, while the “Ultra” ETF performed well over the S&P’s long steady up-trend. This trending is why a 50-50 portfolio of SDS and SSO (US-listed ETFs mentioned in Table 1) would have produced a positive return in 2016 (similar to an option straddle). This example shows that L&I products would be good for low-volatility “alpha strategies” as well as spikes and beta trends.

Factoring in decay

In 2007, an institutional investor in Latin America told me that the S&P 500 UltraShort ETF was among their largest holdings, as it was the only non-derivative product they were allowed as a hedge. These investors seemed to understand how rebalancing and decay worked in this ETF, and had to accept the decay as a cost of not being allowed to trade derivatives.

For most market participants, L&I products are likely to be best used for capturing short-term moves in an index, either as a hedge or a speculation, and mostly considered for the three advantages that they provide over futures:

  1. Lot sizes are typically smaller than the value of a single futures contract;
  2. Unlike a futures margin, investors are guaranteed not to lose more than the purchase price of L&I shares; and;
  3. If the index trends in the investor’s favour several days in a row, the increased exposure from the automatic rebalancing will outweigh any decay.

Time decay is why L&I products are ideally suited to day trading, generally best held no longer than the length of a trend in the underlying index (often days, sometimes weeks), and usually not suitable even for aggressive long-term investors. The need to understand how leveraging AND rebalancing works is why I strongly believe L&I products are only suitable to investors who solidly understand – and so should be eligible to trade – futures and options, and seek one of the specific advantages listed above.          

* Tariq Dennison, CFP, is a discretionary portfolio manager at GFM Asset Management in Hong Kong (www.gfmasset.com), where he runs diversified strategies for clients across Asia and North America.