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From what I understand, investing is leveraged ETFS is generally for short term holders such as day and swing traders because they rebalance nightly and over the long haul don't provide the returns that the non-leveraged ETF does.

I also read that the reason why is because they are rebalanced overnight. Why must they do this? Why couldn't Vanguard/Blackrock say "Ok, this is a 3x leveraged 2015 basket S&P500 ETF" where they never again touched that portfolio and let those positions size up according to growth?

I might be missing a fundamental component here so thanks for the help.

Gerold Astor
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2 Answers2

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Suppose that a 2x leverage ETF has a starting value of $100 and it rises 10% immediately. It's now worth $110. In order to maintain 2x leverage, it must add another $10 of leverage because the leverage ratio is now less than 2x.

Conversely, if the ETF's price decreases, the leverage ratio exceeds 2x. If the ETF does not rebalance, the leverage ratio strays from 2x and will not deliver as promised. Some leveraged ETFs do not reset nightly

Here's an article that explains it. Scroll down until you get to the paragraph titled: Rebalancing Process https://etfdb.com/leveraged-etfs/under-the-hood-of-leveraged-etfs/

A secondary reason for rebalancing is because of M&A in the underlying index that the leveraged ETF is tracking. That has nothing to do with the nightly rebalancing done to maintain leverage. All ETFs change components as the underlying index changes.

Bob Baerker
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To maintain a constant leverage ratio greater than 1x, an ETF must rebalance. This takes the form of buying high and selling low, which produces the lag effect.

However, you may be asking, why does an ETF have to promise to maintain a constant leverage ratio? Couldn't it advertise that, after buying an index with some initial leverage, it will passively keep the same position size per share, allowing leverage to change with the market? (This is separate from adjusting for corporate actions or composition of the index itself.) As far as I know, it could, but this would be less useful to investors/traders for three reasons:

  1. Anyone buying or holding the ETF as time goes on would have to calculate and monitor its current leverage in order to determine the appropriate position size for their hedging or speculation goal. It's easier if name of the ETF tells you (to a good approximation) what the leverage will always be.

  2. If the ETF appreciates greatly, then without rebalancing, its leverage will decrease. Ultimately the leverage would approach 1x (unleveraged) for a "successful" long ETF or 0x (cash-like) for a "successful" short ETF. Then the ETF would lose its raison d'etre. In particular it will not turn, say 7% returns into 21% returns for the long term.

  3. If the ETF depreciates greatly, it will face internal margin calls and a significant chance of going bankrupt. Whereas a 3x daily-rebalanced fund would require a 33% drop in the index in one day to go bust, a non-rebalanced fund with initial 3x leverage would go bust if at any point there is a cumulative drop of 33% from inception. Realistically, before that point, margin calls would effectively force a rebalancing.

nanoman
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