The Return of Negative Compounding

Tony Barchetto, CFA | Chief Executive Officer | tony@saltfinancial.com

  • Markets went for a ride in Q1 2018, but you wouldn't know it looking at just the returns posted by the major US equity indices
  • Volatility resurfaced as a stark contrast to the calm of 2017 and appears to be more than a fleeting visit so far this year
  • The wild swings impacted leveraged ETPs returns in ways that haven't been seen in years, leading to some surprising results

The S&P 500 moved 1% in a day 23 times so far this year and the VIX popped 81% from year end levels, according to calculations by Bloomberg. Yet the market only ended up 0.76% down (total return) for the quarter. Despite the sell-off in Facebook and the other FANG stocks late in the quarter, the Nasdaq 100 managed to stay up for the year at 3.15%. Lacking the technology weight of the S&P 500, the DJIA brought up the rear, losing 1.96%. Inflation and rate hike fears caused the Barclays Bloomberg US Agg index to fall 1.46%, marking the less common occurrence of bonds and stocks selling off together.

The return of volatility was the story of the quarter. The Cboe VIX averaged 17.4 for Q1 but it “felt” worse for a couple of reasons. For one, it was a sharp contrast to the placid calm of 2017 when the VIX stayed barely above double-digits for most of the year. But more importantly, it actually was worse when you look at the average over February/March as January seemed to be a continuation of 2017’s steady levitation in stocks.

The average VIX for the last two months of the quarter was 20.7, with February spending most of the month well above that level. While the blow-up of the short volatility trade and implosion of XIV made headlines, markets remained volatile weeks after the smoke cleared. The early take seemed to be that VIX-related trading, including the ETPs, wagged the dog and “caused” the market to sell-off. But it is more likely a symptom of uncertainty that was creeping into the markets on its own. With a market that topped $30 trillion in size in January 2018, a few billion in short volatility ETPs is not enough to bring down the beast (although they likely made things worse in the short term).

ETF - Cboe VIX

The Side Effects of Leveraged ETPs

As volatility reared its ugly head (or not so ugly if you’re a trader), Q1 2018 also marked the return of a phenomenon that has been dormant for several years: the drag of negative compounding by leveraged ETPs. Daily reset leveraged ETPs boost exposure to an index by using swaps and other derivatives to multiply the daily return on an underlying index (most commonly 2x or 3x). Most leveraged products also offer inverse versions, allowing investors to bet against the index with the same 2x or 3x multiple.

Volatility impacts the compounding of returns for all investments–unleveraged or leveraged. If you lose 10% today, you must gain 11.1% tomorrow just to break even. Leveraged ETPs magnify this effect in two ways. For one, they use derivatives to create leveraged exposure to the market for the day, increasing the magnitude of gain or loss. Secondly, the daily reset (rebalancing) process tends to exaggerate the effect, as the funds are forced to increase exposure when the market goes up and reduce exposure when the market goes down to meet their daily return mandates. Combining the two can lead to some unexpected effects for investors that don’t truly understand the mechanics of these products.

In trending markets, the compounding can benefit and meet or even exceed the 2x or 3x multiple of the underlying index over a period longer than one day. For example, for the 18-month period from June 2016 through December 2017- a very strong uptrend in the market with relatively low volatility-an investment in the Direxion Daily S&P 500 Bull 3x (triple leveraged exposure to the market) returned 109.5%, a 3.5x multiple of the gain in the S&P 500 (31.3%). But in choppier, more volatile markets, it is possible to get the direction of the trade right – and still lose money due to negative compounding of returns from the daily reset.

The table below shows YTD returns through March 29th for the most popular 2x/3x leveraged long and inverse versions of the S&P 500 and Nasdaq 100 indices compared to the plain vanilla SPY and QQQ:

ETF - Leveraged ETF

With relative strength in the Nasdaq 100 in Q1, the 2x and 3x long QQQ funds posted the only gains in the leveraged group. However, negative compounding chewed up a good portion of the returns, resulting in far less than 3x the return of the Nasdaq 100. In fact, the 2x fund had a higher return than the 3x fund (3.91% vs. 3.75%) despite the lower leverage multiple.

On the short side, neither of the inverse S&P 500 funds were able to eke out a gain despite the SPX dropping 76 bps over Q1, with the 3x short variant (SPXS) losing 156 bps. On the short side for the Nasdaq funds, the compounding effect pummeled the bears, losing close to three times the gain for the QQQ in the 2x inverse fund (QID) and nearly five times (14.60% vs. 2.98%) for the 3x inverse fund (SQQQ).

With the VIX taking off and staying elevated for the quarter, the 2x/3x funds also experienced eye-popping realized volatility themselves. Leveraged S&P 500 funds saw close to 40% annualized volatility for 2x and 60% for 3x. The Nasdaq varieties were even higher at 48% and 72% respectively.

To be fair, none of these daily reset leveraged products are meant to be held for a quarter and the fund sponsors (ProShares and Direxion) do a good a job of disclosing the effects of compounding on leveraged funds on their websites and product documentation. They are designed for short-term trading with very high volumes relative to their size. Used properly, they can be effective tools. But used improperly, they can lead to some unexpected results for investors.

Market volatility has been in hibernation for years, absent some quick drops and pops in late 2014, August 2015, and early 2016 before the calm levitating act of 2017. So far in 2018, the VIX has settled in a range above its long term average in the high teens. If the rest of the year continues with similar gyrations, there could be more dramatic swings in leveraged ETP returns following broad market returns exceeding the -0.76% we witnessed in the S&P 500 in the first quarter. Regardless of what the market will bring, it is important to use the right tool for the job, whether you trade in the short term or invest for the long haul.


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