21.2.5 Leveraged ETF Strategy

Leveraged ETF Strategy

Leveraged ETFs are designed to achieve returns that are multiples of the performance of the underlying index they track. These funds use leverage, or borrowed capital, to increase their market exposure. Typically, a leveraged ETF uses $2 of leverage for every $1 of investor capital, commonly referred to as 2x or double leverage.

How Leveraged ETFs Work

The goal of a leveraged ETF is to generate a return on the borrowed capital that exceeds the cost of acquiring that capital. However, the performance over periods longer than their rebalancing frequency may deviate from the stated leverage due to the path of returns.

For example, consider an ETF designed to deliver double the daily return of a reference asset. If the reference asset’s value steadily increases over the month, the leveraged ETF’s return might exceed double the reference asset’s return. Conversely, if the reference asset follows a volatile path, the leveraged ETF return may be less than double. This phenomenon occurs due to portfolio management strategies inherent in daily leveraged ETFs.

Here’s an illustration:

• You have a leveraged ETF designed to double the daily return of a reference asset.
• If the reference asset increases by 3% from an index value of 100, reaching 103, the ETF’s asset value would rise from $200 to $206 (given $100 of borrowed money).
• The leverage factor would now be less than 2 (Calculate as: $206 / $106 = 1.94).
• To restore the target double leverage, the ETF must increase its leveraged position and borrow more to boost the assets from $206 to $212 (calculate as 2: $212 / $106 = 2).

Key Aspects

• Strategies typically aim to buy more positions in the security if its price falls (averaging down).
• With increased position costs, the ETF becomes more exposed, increasing downside vulnerability.
• Repeated compounding in a volatile market can cause deviations from the targeted multiple of holding period returns.

Investors need to predict not only the overall return but also the return path for optimal utilization of leveraged ETFs.

Investment Strategies Suitable for Alternative Mutual Funds

Many alternative mutual funds must comply with regulatory limits concerning derivative use, leverage, short selling, and illiquid securities. These limitations influence the viable strategies for these funds, favoring the use of certain alternative investment strategies. Here are a few categorized by their liquidity and ease of calculating daily NAVs:

Most Liquid Strategies

• Managed futures/commodities
• Equity market-neutral and long/short equity
• Global macro
• Dedicated short bias
• Merger or risk arbitrage
• Fixed-income arbitrage

Medium Liquidity Strategies

• Convertible arbitrage
• High-yield bonds and distressed securities

Least Liquid Strategies

• Emerging markets
• Private equity and real estate investments

Performance Measurement

Absolute Risk and Standard Deviation

• Absolute risk includes total return variability from all risk sources.
• Standard Deviation: Measures dispersion around an average return. Monthly figures often annualized via $ ext{annualized standard deviation} = ext{monthly standard deviation} imes ext{sqrt}(12)$.

Skew and Kurtosis

• Skew: Tilt toward negative or positive returns. Positive skew favors the right side returns.
• Kurtosis: Measure of return concentration around the average (distribution tails). High kurtosis means extreme returns are more likely.

Downside Risk Metrics

• Drawdowns, maximum drawdown, and time to recovery.
• Percentage of profitable and losing months.
• Sharpe Ratio: Plan of manipulating the risk/reward ratio via $$ ext{Sharpe Ratio} = rac{R(a) - R(f)}{ ext{SD}(a)}$$

Due Diligence and Suitability of Alternative Funds

Key Due Diligence Questions (outlined by AIMA, 2018)

Investment Manager Questions

• Background, governance, and risk management frameworks?
• Senior management personal investments in the fund?

Strategy Questions

• Investment objective and adaptable history?
• Risk management methods?
• Financial leverage?

Comprehensive Eight-Stage Due Diligence Process

Main areas include: investment manager experience, compliance culture, compensation methods, and detailed fund structure review.

Suitability

Alternative strategies have diverse objectives, strategies, and underlying portfolios. Therefore, suitability depends on the following investor characteristics:

• Outstanding portfolio theory knowledge.
• Specific outcome-focused objectives.
• Medium-term investment horizon.
• Short-to-medium term liquidity needs.

Glossary

Key terms to know:

• Leverage: Use of borrowed funds to increase the investment size.
• Net Asset Value (NAV): The value per share of a mutual fund.
• Standard Deviation: A statistical measure of return dispersion.
• Sharpe Ratio: Ratio indicating risk-adjusted returns above a risk-free rate.
• Drawdown: Peak-to-Trough decline in fund value, expressed as percentage losses.
• Skew and Kurtosis: Measures for assessing distribution character of investment returns.

Summary

Summarized key points about leveraged ETF strategies, suited alternative mutual fund strategies, performance assessment using risk measures, diligence in alternative investments, and strategic suitability assessments.

Review Questions

1. Explain the rebalancing strategy of leveraged ETFs and its implications.
2. What measures help appraise downside risk in alternative strategies?
3. How does skewness and kurtosis distinction aid in risk analysis?
4. What factors should be checked about investment managers during due diligence?

Frequently Asked Questions (FAQs)

What is a leveraged ETF? A leveraged ETF is a fund that uses financial derivatives and debt to amplify returns on an underlying index.

Why does a leveraged ETF not always yield exact multiples of the underlying index over extended periods? Due to path dependency and daily rebalancing, a leveraged ETF’s performance can deviate from exact multiples during volatile periods.

Which investors are suitable for alternative mutual funds? Those with excellent portfolio theory understanding, medium-term horizons, and specific outcome focuses.

What tools can investors use for risk-adjusted performance evaluation? Tools such as Sharpe ratio, drawdown measures, and skew indexes.

Remember to accurately respond to review questions and FAQs after reading the text. Conduct more examples and learning activities to strengthen understanding of leveraged ETF strategies and alternative investments.

Consider well-preparing for traditional fund vs alternative fund control verification processes through regulatory audit confirmation.