Compounding in Practice: When the Market Is Highly Volatile and Moving Sideways
It is Sunday evening, and Jill believes the market will trend upward tomorrow. On Monday morning, she buys $100 of a daily 3x leveraged long ETF. On the first day, the benchmark index falls 5% to 95, and Jill’s ETF drops 15% to $85, with current market exposure of $255.
On Tuesday, the benchmark index returns to 100, a 5.6% gain. Jill’s ETF earns three times the index’s daily return, rising 15.78% to $98.42, with total exposure of $295.26. On Wednesday, the benchmark continues higher, rising another 5% to 105. Jill’s ETF climbs to $113.18, with exposure of $339.54. On Thursday, the benchmark stops rising and falls 4.76% back to 100. Jill’s ETF drops 14.29% to $97.02, with exposure of $291.06. On Friday, the benchmark falls another 5% to 95, and Jill’s ETF falls 15% to $82.46, with exposure of $247.38. The following Monday, the benchmark returns to 100, up 5.26%, and Jill’s ETF rises 15.79% to $95.48, with exposure of $286.44.
Scenarios like this have a major impact on leveraged ETFs, because daily leveraged long ETFs respond to market or index gains by increasing exposure, and to market or index losses by reducing exposure. So each day’s market move changes Jill’s level of exposure. With the index swinging up and down but starting and ending at 100, Jill’s daily 3x leveraged long ETF is hit by negative compounding and ends with a loss of 4.52%.
Overall, if an investor like Jill holds a daily leveraged long ETF for more than one day, the ETF’s final cumulative return may be greater or less than three times the benchmark index’s cumulative return, because compounding changes the level of daily market exposure. In the first example, during a steady uptrend, Jill’s daily 3x leveraged long ETF earns far more than three times the benchmark’s cumulative return. In the second example, Jill’s total loss is far smaller than three times the benchmark’s cumulative loss. In the third example, even though the index ends unchanged after six days of volatility, Jill still loses money.
Importantly, across all three scenarios, the ETF Jill bought performs exactly as daily leveraged ETFs are designed to — adjusting risk exposure based on single-day returns. But when the index moves over a period longer than one day and the leveraged or inverse ETF rebalances daily, positive or negative compounding emerges. That causes the final cumulative return from holding a leveraged or inverse ETF for more than one day to differ from three times the benchmark’s cumulative return — sometimes by a wide margin.
This presentation is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. Read more