by Steve Auger
A few weeks ago a light bulb switched on in my head; well actually it was a CFL not an incandescent as the light was slow to come on and started out rather dim. The idea has to do with leveraged ETFs. Many of the companies providing these instruments are getting sued for not properly informing investors of the inherent dangers with them.
The reason they are "dangerous" is that they provide leverage (x2, x3, etc) on a daily basis but not long term. Daily compounding results in significant skew from the underlying index. Let's examine this a little closer by comparing the results of an underlying index versus a typical x3 leveraged fund.
Day 1 102 +2.00%
Day 2 100 -1.96%
Day 3 102 +2.00%
Day 4 100 -1.96%
Day 1 106 +6.00%
Day 2 99.76 -6.24%
Day 3 105.75 +6.00%
Day 4 99.53 -6.22%
As you can see from this simplified example, the non-leveraged index broke even over four days. The index started at 100 and finished at 100. Whereas the x3 leveraged fund lost 0.48%. How can this be??? It is the simple result of daily compounding on a leveraged instrument.
The characteristics of leveraging are as follows:
- Long trend up or down without reversals will result in highly leveraged profits (or losses)
- Volatility will result in decreasing value regardless of long term direction.
- ALL leveraged ETFs will lose money over the long term.
With this in mind I decided to go about making a speculative stock system based on the long term degradation of leveraged ETFs. I will explain more over the next few posts.