Index Construction
Leveraged indices are calculated based on the performance of their un-levered reference indices. Let’s take the FTSE 100 Index as an example.
The FTSE 100 Index is a free float market capitalisation weighted index that offers exposure to the 100 largest UK stocks. It represents about 85% of the market capitalisation of the London Stock Exchange and around 8% of the world’s equity market capitalisation. The constituents of the index are determined quarterly. The index consists of 100 companies, for a total of 102 listings as two classes of shares are included for Royal Dutch Shell and Schroeders.
The leveraged index is calculated as two times (minus two times in the case of the inverse ETF) the return of the FTSE 100 Index minus the financing component (plus the interest component for the short ETF) over the reset period. Here, the financing component is a function of an interest rate that represents the cost of borrowing to obtain leverage. Currently, the 1 month Euribor (DAX, EURO STOXX 50, FTSE MIB) and the 1 month GBP Libor (FTSE 100) are used. However, the S&P GSCI Capped Component 35/20 2x Leverage/Inverse Monthly Return ETF has no interest/financing component embedded in the performance calculation.
Depending on the reference index, the leverage is either reset on the third Friday of each month (in the case of its DAX and EURO STOXX 50 funds), or the last business day of the month (in the case of those funds linked to the FTSE 100, FTSE MIB, and S&P GSCI Capped Component 35/20).
In addition, the indices have a built-in stop-loss mechanism to limit the effects of extreme intra-month declines in the value of the reference indices. This mechanism is activated as soon as the reference index has either declined (in the case of the leveraged long indices) or risen (in the case of the leveraged short indices) by more than 40% since its last reset day. Once the stop-loss level is reached, the leverage factor is reset to two and the closing price on that day is the new reference point for subsequent calculation.
As you can imagine, higher interest rates will have a negative impact on leveraged long products and a positive impact on inverse leveraged products. Generally speaking, the higher the funding rates in the market, the greater the divergence will be between the leveraged or inverse ETF as compared to a simple +/- 2X the reference index’s performance over any given span.
Fund Construction
The leveraged long and short ETFs from RBS use swap-based replication to track their reference indices. RBS uses unfunded swaps. Under this model, each ETF buys and holds a basket of securities (i.e. the fund holdings/substitute basket) and simultaneously enters into a swap agreement with a single counterparty, Royal Bank of Scotland NV, which commits to pay the index performance (adjusted for the swap spread) in exchange for the performance of the fund’s holdings.
As mentioned earlier, investors should be aware of the fact that there is no leverage at the fund level. The leverage is embedded in the index calculation and no party actually borrows or lends in order to achieve leverage.
Looking at monthly performance statistics, the RBS monthly leveraged products have delivered returns very near the expected+/-2X their reference benchmarks, in most cases. Part of the “mis-performance” seen above can be explained by fees and financing costs. The low tracking difference (again versus a simple +/- 2X the unleveraged reference indices) is partly explained by the current low financing costs. Once interest rates rise, it is expected that tracking differences will increase as well. Moreover, if the index performance between the reset days is relatively flat, e.g. the EURO STOXX 50 Index in May, the fees and financing costs will have a large impact on the leverage ratio, as the table above indicates.
When we calculate the performance ratio over several months (since inception in this case) we see that these products’ performance ratio can deviate quite substantially from a +/- 2X their underlying benchmark—much as is the case when holding daily leveraged and inverse products for periods longer than a single day. In particular, the inverse 2X DAX ETF has declined 1.81% since inception whereas the DAX’s performance over this same span of -1.43% multiplied by -2 would indicate a theoretical implied return of 2.8%.
Summary
So are leveraged and inverse ETFs right for you? We strongly recommend that only sophisticated investors make use of these very complex and risky vehicles and do so only over short periods of time.
Leveraged and inverse products perform exactly how they are supposed to—though not how some might expect them to. The 2X daily leveraged ETFs return twice the performance of their reference indices on a daily basis and are therefore suitable for professional investors with very short-term expected holding periods. The 2X monthly leveraged ETFs return twice the performance of their reference indices on a monthly basis (again, assuming that they are purchased on the monthly reset date). Therefore, the leveraged products from RBS can provide leverage to investors who are particularly bullish or bearish on the near-term prospects of their respective reference index. These products are most suitable for short-term hedging of existing exposures or to take short-term leveraged bets on the underlying. However, the desired 2X leverage is only guaranteed when bought on the reset day and until the next reset day. If bought intra-month a different leverage factor will be locked in until the next reset day; depending on the current index level compared to the last reset day.
Once investors’ holding periods exceed one day and one month respectively, these products’ returns can deviate quite substantially from a simple multiple of the return of their reference index.
In the eyes of some investors these monthly leveraged ETFs from RBS surely represent an improvement upon daily leveraged products as they lock in a known leverage factor until the next reset day and thereby reduce the compounding issues intra-month. This could be particularly useful in high volatile market environments. But despite the improved structure, the ETFs from RBS are still leveraged products and will inevitably suffer from similar drawbacks as daily leveraged products over the long run. Moreover, the 2X leverage is not guaranteed if bought intra-month. Thus, investors must understand the mechanics of these products and the risks attached to them in order to determine a suitable investment horizon. The inherent characteristics of these ETFs make their usefulness somewhat limited as they are only suitable for sophisticated investors with a very short time horizon.
