The Trap in Leveraged and Inverse ETF Charts: Daily Rebalancing and Volatility Decay

What leveraged and inverse ETFs are

A leveraged ETF is designed to deliver two or three times the percentage move of its underlying index in a day, and an inverse ETF is designed to move in the opposite direction. In Korea many are built on the KOSPI 200, and in the US on the S&P 500 or Nasdaq-100. The name suggests that if the index rises 5% in a month, a 2x product should rise 10%, but what most of these products promise is a multiple of the daily return. That one word, daily, is what makes the charts drift further apart the longer you look.

What daily rebalancing does

For a 2x product to deliver exactly twice the index every day, it has to readjust its exposure at each close to match its new asset value. This is called daily rebalancing, and it has a few traits.

• After an up day it increases exposure, and after a down day it reduces exposure
• That makes it a trend-following structure that buys more after gains and holds less after losses
• The multiple holds well for a single day, but strung over many days, compounding pulls it out of line
• Inverse products also reset their opposite exposure daily, so they face the same problem

Volatility decay with made-up numbers

This is a hypothetical example to explain the idea, not a real product, and it assumes no costs or tracking error. Say an index starts at 100, rises 10% on day one and falls 10% on day two.

• Index: 100 to 110, then 99, a 1% loss over two days
• 2x product: 100 to 120, then 96, a 4% loss (more than 2%, twice the index loss)
• -1x inverse product: 100 to 90, then 99, the same 1% loss as the index
• So even when the index only swings around the same level, the multiplied product gets worn down

Optical illusions on the chart

Look at the chart without knowing this structure and a few illusions appear. The classic one is an index that has returned to its price of a few months ago while the 2x product sits well below its own price from that time. On the other hand, in a period of steady gains in one direction, the 2x product can seem to have risen more than twice the index. Neither is a calculation error; both come from daily rebalancing and compounding. An inverse product's chart is also not the index chart flipped upside down. Even in a falling trend, repeated days of sharp rebounds can keep an inverse product from rising as much as you would expect.

Trending markets versus sideways markets

Volatility decay shows most clearly in a sideways market that swings hard without direction. The bigger the daily swings, the longer the period and the higher the multiple, the more gets worn away. In a calm market that trends steadily one way, compounding works in your favour and the period return can even exceed the index multiple. You cannot know in advance which you will get, so do not picture a leveraged or inverse product's long-term chart as the index chart multiplied. What you need to read on the chart is not just the direction but how rough the ups and downs were over that period.

What to check when you open the chart

When you open a leveraged or inverse ETF chart, run through these points in order. The same chart becomes much less confusing.

• Check the prospectus for whether the target is a multiple of the daily return and what the underlying index is
• Overlay it with the underlying index, both started at 100 on the same day, to see the size of the drift
• Look at whether the index moved in one direction over that period or swung widely
• Check costs such as the expense ratio, and currency effects for foreign products, in the official product documents

Check it with this site's live tools

Put the underlying index, a plain ETF tracking it and a leveraged or inverse ETF into the stock comparison tool, and you can see their cumulative paths started at 100 on the same day side by side, along with volatility and maximum drawdown. Products not on the list can be added through manual entry. Change the period to see how the drift differs between trending and sideways stretches. It also helps to find a period when the underlying index fell sharply in the index drawdown and recovery tool and compare the same dates. Prices may be delayed.

Things to keep in mind

This guide explains how to read leveraged and inverse ETF charts; it is not investment advice and does not encourage trading any product. The numbers above are a made-up example to show the structure, not the performance of any real product. Multiplied products multiply losses too, and the longer you hold them, the further they can drift from the index. In Korea, individual investors may need to meet requirements such as completing an advance training course before trading these products, so check trading conditions and costs in the official information from your broker and the fund manager.