Compounding in Practice: When the Market Trends Steadily Upward

“Compounding” can occur in any investment, but its impact on leveraged and inverse ETFs is especially pronounced. Why is that? As we explained earlier, these ETFs seek 300% daily exposure and aim for three times the benchmark index’s daily return. The 3:1 exposure ratio is rebalanced every day. Daily rebalancing is necessary to achieve and maintain the daily investment objective. Because most of these ETFs are designed to pursue their daily targets, if an investor holds them for more than one day (weeks, months, or even years), daily rebalancing can significantly increase or decrease the ETF’s position in its tracked index. Over time, that can cause the ETF’s cumulative return to diverge materially from the cumulative performance of its benchmark. The constantly shifting level of exposure means investor returns may differ over the long run — sometimes substantially from three times the index’s cumulative return.

This section explains how compounding works in practice. We will use Jill’s 3x leveraged long ETF to illustrate how compounding affects returns and how different market trends continually change exposure levels. We will walk through three scenarios: first, when the market trends steadily upward; second, when it trends steadily downward; and third, when the market is flat but highly volatile. Note that all figures in these examples are before fees and expenses. In this hypothetical case, the index starts at 100 and rises by 5 points each day — a relatively large single-day move.

When the market trends steadily upward. It is Sunday evening, and Jill has a strong feeling the market will rise tomorrow. On Monday morning, she buys $100 of a daily 3x leveraged long ETF. Because the ETF uses 3x leverage, Jill’s effective exposure to the benchmark index is $300. Jill turns out to be right: at Monday’s close, the index rises to 105, a 5% gain. Her $300 of index exposure gains 5% to $315, giving her a 15% return, or $15. The daily 3x leveraged long ETF is now worth $115. After rebalancing, the ETF’s exposure to the benchmark index rises to $345.

Although the leveraged ETF’s objective is clearly stated as seeking to track the benchmark’s daily return, Jill chooses to keep holding it because she believes the index will continue rising the next trading day. On Tuesday, she is right again: the benchmark rises another 5 points, from 105 to 110, a 4.76% gain. Her $115 ETF rises 14.28% to $131.42. The index’s two-day total gain is 10%, and with daily rebalancing in a rising market, the leveraged ETF compounds favorably. Its cumulative return reaches 31.4% — 1.4 percentage points more than three times the index’s cumulative gain. At Tuesday’s close, Jill’s ETF is worth $131.42.

On Wednesday, Jill continues to hold her 3x leveraged long ETF as the uptrend persists. The benchmark rises another 5 points to 115. By Wednesday’s close, the benchmark is up 15% for the week, but daily rebalancing after each favorable move produces a positive compounding effect. Jill’s three-day total return reaches 49.35%, more than three times the index’s 15% cumulative gain. Her leveraged ETF is now worth $149.35.

Suppose the rest of the week continues in the same upward pattern. On Thursday, the index rises another 5 points to 120. The index is now up 20% in total, but Jill’s leveraged ETF has gained 68.83% — well above 60%, or 20% times three. On Friday, the index rises another 5 points to 125, and Jill decides to sell. Her ETF is now worth $189.94. So although the index’s total return for the week is an impressive 25%, Jill’s daily 3x leveraged long ETF returns 89.94% — higher than 75%, or three times the index’s cumulative gain. Daily rebalancing also increased her daily risk, but with the market rising each day and positions being added through daily rebalancing, favorable compounding pushed the ETF’s weekly return to 89.94%.

That total return is what Jill earned in just one week of a sustained rally, because she understood that as the tracked index rose each day, the ETF’s exposure to the index grew rapidly as well. In just five days, her market exposure nearly doubled relative to her initial investment. Such a large exposure level also means very high market risk. If the market turned down or moved sideways for any reason, her cumulative losses could be far greater than what she might lose on day one. As a professional investor, Jill can recognize when exposure and risk in her position are rising. Even if she still believes the market will keep rising, she may sell part of her ETF to reduce exposure — perhaps by an amount equal to the gains she earned this week. Monitoring exposure levels is essential for investors in leveraged and inverse ETFs.