Five things to know before investing in short & leverage ETPs

Feb 15th, 2017 | By | Category: ETF and Index News

By Nizam Hamid, Head of Strategy at WisdomTree in Europe.

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By Nizam Hamid, Head of Strategy at WisdomTree in Europe.

Leverage has been around for hundreds of years and, today, there are many different types of short and leveraged instruments – from notes, to funds, to certificates – listed on exchanges globally.

Because of the combined features of leverage and daily compounded returns, these types of trading instruments can enhance returns and be a robust, transparent, secure and cost-effective trading tool.

As a provider of short and leverage ETPs through our Boost product range, we want investors to clearly understand how these products work before trading them.

  1. Leveraged returns allow an investor to magnify the returns (positive and negative) of an unleveraged investment.

For example, suppose you invest in an ETP which tracks the FTSE 100 and is 3x leveraged. When the FTSE 100 rises 1% in the trading day, then your ETP will also rise by 3% (excluding fees and adjustments).

If you had invested in the 3x short ETP product tracking the FTSE 100, that ETP would have risen by 3% (excluding fees and adjustments) if the FTSE 100 fell by 1%.

Conversely, if the FTSE 100 rises or falls by 1% on any day, the ETPs offering 3x short or long exposure, respectively, will lose 3% on such day (excluding fees and adjustments).

  1. Leveraged products allow investors to either use less of their capital to achieve a desired level of exposure, or to magnify their exposure using the same amount of capital.

In the case of 3x leverage, you would only actually invest 1/3 of the total exposure.

How? For example, if an investor buys £100 of a 3x Leverage Daily ETP, the investor receives £300 of exposure which actually consists of £100 cash and £200 of borrowed funds (charged at reference market funding rates) to achieve an investment of £300.

The borrowing cost is deducted from the daily return and is either incorporated into the index or is incorporated in the calculation of the ETP price (together with other fees and adjustments).

If an investor buys £100 of a Boost 3x Short Daily ETP, £300 of the index is borrowed and sold short.  The £400 cash (£100 from the investor and £300 from the short sale of the index) is then invested at interbank cash rates. The cost of the stock-borrow and interest income on the cash is incorporated into the calculation of the ETP price each day.

  1. There’s a reason why ETP providers incorporate rebalancing (which is usually daily).

Leveraged ETPs seek to offer a stated multiple (that is, the leverage factor) of the performance of their benchmark over a period of time.

This period of time is typically one day. This means that leveraged ETPs need to rebalance the leverage at the end of each trading day to ensure they offer investors the same leverage factor on each new trading day. If weekly or monthly leveraged was used, the exposure for investors would depend on what day of the week or month they bought the investment and would change with the movement of the underlying index.

Over time, this may lead to extreme results (for example, exposures greatly in excess of the stated leverage factor). Since ETPs are open-ended and can be created and redeemed daily, daily rebalancing allows investors to buy and sell the ETP on any date and still receive the stated leverage factor.

  1. Compounding needs to be taken into consideration for ETPs held over periods longer than one day and can have both negative and positive effects.

Consider a scenario where the FTSE 100 moves up and down with no clear trend.

You now know that if the FTSE 100 price is £100 and rises by +5%, your 3x FTSE 100 Leverage Daily ETP will rise by +15% to £115 (excluding fees and adjustments).

But then the next day, if the FTSE 100 falls by -5% that ETP will fall to £97.75. Over two days, the FTSE 100 would have an average return of 0% and a price of £99.75 resulting from a two-day compounded return of -0.25%. While you’d expect a return on the ETP of three times the index returns (or -0.75%), the two-day compounded ETP return is -2.25%.

Consider now a scenario where the FTSE 100 is trending upwards, returning +5% on each of two consecutive days. £100 invested in the FTSE 100 would return £5 on the first day and £5.25 on the second day, with an end of day value of £110.25 (or 10.25% return over the two days). Your 3x FTSE 100 Leverage Daily ETP would have returned £15 on the first day and then £17.25 on the second day, resulting in a two-day compounded price of £132.25 or a return of 32.25%.

This return would exceed three times the 10.25% return of the FTSE 100 (or 30.75%) you’d expect to have made with a 3x FTSE 100 Leverage Daily ETP.

Daily rebalancing produces “compounded” returns, which can have a positive or a negative impact. The magnitude of this daily compounding effect depends on the length of a holding period, the volatility of the index and the leverage.

  1. Different ETP providers and instruments offer varying degrees of protection for both your initial capital and consequent losses (or gains).

For that reason, you should always ask your provider what those measures are.

For example, you may want to know what would happen if there was an extreme market move, say in the FTSE 100. Is there an intra-day rebalancing mechanism which would prevent your leveraged ETP tracking the FTSE 100 falling to £0 in one day? Could your ETP be closed out?

Boost ETPs are over collateralised, transparent, exchange traded products and they have a built-in intraday reset mechanism designed to prevent the product from such eventualities.

Another thing to note is that Short & Leveraged Exchange Traded Products are not the same as CFDs, futures or options. Investors should always check whether more than their initial capital could be at risk. Investors in Boost ETPs can never lose more than their initial investment.

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