Compounding in Practice: When the Market Trends Steadily Downward
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, giving her $300 in market exposure. But Jill is wrong: the benchmark index tracked by her ETF falls 5%, dropping from 100 to 95. Her daily 3x leveraged long ETF loses 300% of the index’s single-day loss — down 15% — leaving the ETF worth only $85. That means at the start of Tuesday’s session, Jill has only $255 in market exposure.
In this situation, a cautious investor might reduce position size or cut losses. To explain the concept further, however, we will continue with the example.
On Tuesday, the index falls from 95 to 90, a 5.2% decline. Jill’s ETF falls 15.78% to $71.58. On Wednesday, the index continues down to 85, losing another 5.56%. Jill’s ETF falls to $59.65, with market exposure down to just $178.95. On Thursday, the index falls another 5.88%, and Jill’s ETF drops 17.64% to $49.12, leaving $147.36 in exposure. On Friday, the index falls again to 75, down another 6.25%, and Jill’s ETF falls 18.75% along with it.
After a full week of the index falling 5 points each day, Jill’s ETF is worth only $39.91, with total exposure of just $119.74. Overall, the benchmark index fell 25% for the week. Daily rebalancing reduced market exposure each day, and the sustained decline produced a favorable compounding effect. Jill’s ETF recorded a steep loss of 60.09%, but that was still less than three times the index’s weekly cumulative decline, or -75%.
Through daily rebalancing, the ETF reduces market exposure from its assets to ensure that exposure remains equal to three times the ETF’s net asset value. Ultimately, under the daily rebalancing mechanism — where positions are reduced each day when market or index moves work against the leveraged ETF held — Jill’s total loss is far smaller than the total loss she would have recorded without daily rebalancing.
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