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A US manager has filed to launch the first leveraged and inverse exchange traded funds designed to reset over longer periods, offering a solution for investors who risk losing out if they intend to hold for more than a day.
New York-based AXS Investments’ proposed suite of 50 ETFs would offer weekly, monthly and quarterly resetting on 2x long exposure to a dozen ETFs managed by rival issuers, which track underlying exposures such as the S&P 500, Nasdaq 100, bitcoin, Nvidia and Tesla. Similar tenor short exposure would also be available on some of these ETFs.
There are about 150 leveraged and inverse ETFs already trading in the US, with a combined $94.9bn in assets as of the end of April, according to data from Morningstar Direct. Some products have proved hugely popular, with 3x Nasdaq ProShares UltraPro QQQ (TQQQ) currently holding $22.4bn.
However, as all of these products reset on a daily basis, they suffer from so-called volatility drag (see below). This means the longer the vehicles are held and the greater the volatility, the more likely it is that performance will deteriorate.
AXS’s proposed ETFs, which would be branded as Tradr ETFs, would get around this problem for those who held them for their stated reset period, although volatility drag would still set in after this point.
“We have run a lot of data. Investors are holding daily reset ETFs for longer than a day, sometimes a week, a month and we have had anecdotal feedback from clients of other firms sometimes for a year,” said Matt Markiewicz, head of product and capital markets at Tradr ETFs.
“They are getting to experience this volatility drag that is common with all these products. There is a massive need for products with a longer reset.”
William Trainor, professor of finance at East Tennessee State University, who has studied the impact of different rebalancing periods, broadly agreed. He has described daily rebalancing as a “major drawback for investors with longer-term horizons”.
“Personally, I prefer the monthly [reset]. It’s a little less volatile, especially if you are a long-term holder. For holding periods of six months or less, I think the monthly is a lot better than the daily,” said Trainor.
His analysis of monthly vs daily suggested “the advantages dissipate substantially beyond six months”. A quarterly reset period should be able to push this limit out further, although Trainor feared “the financing costs are going to be way more expensive” for such ETFs, given that issuers typically use swap contracts to gain the necessary leverage, which involves posting collateral with the swap counterparties.
Another issue, Trainor said, is the exact 2x leverage would only apply for those who bought a product as soon as it reset. Anyone buying part way through a reset period would be getting either less or more leverage than this, depending on whether prices have risen or fallen in the interim.
Nevertheless, Trainor was “intrigued” about the quarterly resetting inverse funds that Tradr ETFs proposes launching on ETFs tracking the S&P 500, the Nasdaq 100 and the NYSE Semiconductor index.
“They might be of use as short daily funds get destroyed with market vol”, if held for any length of time, he said.
“Locking in a quarter of -2x with no decay due to vol may actually make that fund useful for hedging, meaning if the market falls, you can guarantee a win with -2x,” Trainor said.
“Usually the volatility that goes up during declining markets mitigates any gains. Anyone who holds [daily resetting inverse ETFs] for more than a week is crazy.”
There are a handful of US-domiciled mutual funds that use monthly rebalancing.
Guggenheim Investments has run a Monthly Rebalance Nasdaq-100 2x Strategy since 2014. Direxion operates seven mutual funds, launched between 1999 and 2016, that offer between 1.2x and 1.75x the S&P, Nasdaq, small-cap Russell 2000 index and the Solactive High Yield Beta index, as well as bull and bear exposure to Treasury bonds.
The Guggenheim fund holds just $778mn and the Direxion ones have $615mn between them, but the prevailing view is most people who use leveraged and inverse products have migrated to ETFs.
Investors have an “increasing preference for exchange traded products over mutual funds, especially given the transparency, intraday liquidity and tax efficiency of the ETF wrapper”, said Markiewicz. Hefty minimum investments can also be an issue for some mutual funds, he said.
This might suggest AXS might have more success in raising assets via ETFs. One other hurdle remains, though.
Direxion filed to launch its own monthly resetting ETFs in 2010 but withdrew the applications. It is believed that, at that time, the US Securities and Exchange Commission was not comfortable with the concept.
However, the passing of the Derivatives Rule (limiting funds to 200 per cent leverage) and the ETF Rule (which eased the creation of new ETFs) in the subsequent period may have helped clear the path for monthly resetting funds.
Despite the introduction of these rules, Markiewicz argued that leveraged and inverse ETFs “haven’t really evolved much” since first appearing in 2006, with the exception of the launch of single-stock ETFs in the US in 2022 — pioneered by AXS, which manages $1.1bn in mutual funds and ETFs.
If approved, the first ETFs are likely to launch on August 1, with the monthly versions debuting first.
What is volatility drag?
Volatility drag impacts all investments, but is particularly problematic when the underlying security is volatile, which is more likely for leveraged or inverse exposures than for plain vanilla investments that track their underlying assets on a one-for-one basis.
The following scenario helps explain how it works: if an investment rises 60 per cent in one time period but then falls 40 per cent in the second, this may sound positive overall. However an investor would have actually lost 4 per cent: $100 initially became $160, before falling to $96 after the second time period.
This divergence occurs because of an inherent asymmetry: a negative return has a disproportionately larger negative effect compared with a positive return of the same magnitude.
As an illustration of how this might work in real life, Professor William Trainor ran 20,000 simulations based on an underlying index that rises between 8 per cent and 12 per cent over a year with a standard deviation (a measure of volatility) of 40 per cent.
An unleveraged fund thus has a guaranteed return of 8-12 per cent. However, despite the index rising during the year, Trainor found that a 2x leveraged fund (with a daily reset) had an average return of just 3.1 per cent. The returns from the individual simulations varied widely, ranging from a loss of 5 per cent to a gain of 10.5 per cent.
A 3x daily resetting fund fared worse still, with an average return of minus 17.7 per cent. The returns ranged from -32.5 per cent to -3.7 per cent, ie guaranteeing a loss.