Daily Rebalancing Mechanism
You may recall that we said earlier Jill’s leveraged ETFs are designed to seek 300% of the daily return of a U.S. large-cap index. Given that objective, the fund manager must rebalance the portfolio every day to maintain the ETF’s target exposure. As a seasoned professional investor, Jill knows that daily rebalancing continually changes her level of market exposure, which can significantly affect how closely the ETF tracks its benchmark from the time she first buys it. If she holds the position for more than one day, her leveraged ETF exposure could rise or fall sharply, affecting her original investment.
Let’s look at how a leveraged ETF rebalances daily in rising and falling markets. To keep the example simple, we’ll assume all figures are whole numbers, and that Jill bought a leveraged ETF with $100 million in net assets at the start of the trading day. Based on the ETF’s daily investment objective, its corresponding exposure is $300 million, or 300% of net assets.
If the index rises 1% for the day, the ETF’s exposure gains $3 million for the day, increasing net assets by $3 million to $103 million. Now that net assets have risen to $103 million while total exposure is only $303 million, the ETF’s net assets and total exposure are out of balance, because $303 million is only 294% of $103 million in net assets. At the end of the trading day, to restore balance (total exposure must equal 300% of net assets), the fund must add $6 million in exposure to reach $309 million. Total exposure then equals exactly 300% of $103 million in net assets, and the ETF’s total exposure and net assets are back in balance (total exposure must equal 300% of net assets).
Now let’s see what happens when the index falls by the end of the trading day. If the index drops 1% for the day, the ETF’s exposure falls by $3 million for the day, reducing net assets by $3 million to $97 million instead of $100 million. With net assets now at $97 million, the ETF is out of balance again (total exposure must equal 300% of net assets), because $297 million is 306% of $97 million in net assets, not three times net assets. Near the end of the trading day, rebalancing requires reducing exposure by $6 million. Only then does total exposure return to 300% of net assets, ensuring that at the start of the next trading day, the ETF’s target position and net assets are aligned (total exposure must equal 300% of net assets).
As a responsible investor, Jill understands that the daily rebalancing of leveraged and inverse ETFs — adding or reducing exposure as markets rise or fall — affects her own market exposure and, in turn, her returns from time to time. She monitors her leveraged and inverse ETFs carefully every day to make sure her exposure is neither too high nor too low. She prefers to adjust her positions based on her investment objectives.
As this example shows, daily rebalancing increases or decreases index exposure. For individual investors who hold leveraged and inverse ETFs for more than one day, changing exposure levels and their impact on returns create a “compounding” effect, which we will cover in detail in the next section. We will walk through three main compounding scenarios: first, when the market trends steadily upward; second, when it trends steadily downward; and third, when the market is flat but highly volatile.
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