As investors try to hedge their portfolios or try to enhance returns in an extended bull market environment, consider tactical alternative exchange traded fund strategies.
On the recent webcast (available on-demand for CE Credit), Systematic Tactical Management with Leveraged ETFs, Sylvia Jablonski, Managing Director and Institutional ETF Strategist at Direxion, argued that advisors should look at leveraged and inverse ETFs to hedge rising risks in an extended bull market. These leveraged and inverse ETFs try to magnify the returns of their benchmarks on a daily basis.
Leveraged and inverse ETFs “allow investors to gain exposure without the need for full dollar-for-dollar investment,” Jablonski said.
Investors should also keep in mind that most leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the fund may not perfectly reflect their intended strategies.
A market without long interruptions and relative lack of volatility will help maintain positive gains in a leveraged ETF. Since the ETFs rebalance on a daily basis, compounding effects benefit leveraged ETFs in a consistently trending market. On the other hand, in times of increased volatility, leveraged ETF returns can fall behind their intended 2x or 3x strategies.
“The reason for this is that volatility combined with leverage and compounding leads to decay,” Jablonski said. “In pursuit of their daily investment objectives, leveraged ETFs must rebalance their assets to exposure ratio on a daily basis. This means that their returns over time are the product of a series of daily returns, and not the fund’s beta multiplied by the cumulative return of the index for periods greater than a day. This deviation in performance is commonly referred to as compounding.”
Consequently, potential leveraged and inverse ETF traders should closely monitor their positions. During highly volatile periods for a fund’s benchmark index, you will need to adjust your positions frequently to maintain constant exposure levels. During periods of lower volatility for the benchmark index, you should continue to monitor, but position adjustments will likely be needed less frequently.
“Daily rebalancing funds are not meant to be held, unmonitored for long periods,” Jablonski said. “If you intend to hold leveraged ETFs for periods greater than a day, you must always watch them closely.”