How do leveraged and inverse funds reset their leverage exposure?

Leveraged and inverse exchange-traded funds (ETFs) are designed to amplify the returns of their underlying index, often on a daily basis. To achieve this leverage, these funds use financial derivatives, such as futures contracts and swaps. Resetting the leverage exposure in these funds typically occurs daily, and it's essential to understand how this process works:

1. Daily Rebalancing:

• Leveraged and inverse ETFs engage in daily rebalancing, which means that at the end of each trading day, the fund's exposure is reset to its desired leverage level. This process aims to maintain the intended leverage factor, such as 2x or -1x, relative to the underlying index.

2. Compounding Returns:

• Over time, the daily rebalancing process can lead to compounding returns that may cause the fund's performance to deviate significantly from the index's performance, especially in volatile markets.

3. Impact of Volatility:

• High volatility can amplify the divergence between the ETF's performance and the index. If the market experiences substantial fluctuations over multiple days, the cumulative impact of daily rebalancing can lead to substantial tracking errors.

4. Understanding Leverage Factors:

• Leveraged ETFs seek to achieve a multiple of the daily returns of the underlying index. For example, a 2x leveraged ETF aims to deliver double the daily return of the index. An inverse ETF (-1x) seeks to provide the inverse daily return.

5. Daily Percentage Changes:

• The daily reset means that the ETF's performance is based on the percentage changes in the index from one trading day to the next. It does not aim to provide a leveraged or inverse return for longer periods.

6. Impact on Long-Term Performance:

• Due to the daily resetting of exposure, the performance of leveraged and inverse ETFs can significantly deviate from the expected returns over extended periods. These ETFs are primarily designed for short-term trading or as tactical tools, not for long-term buy-and-hold strategies.

7. Risks and Considerations:

• Investors should be aware of the risks associated with leveraged and inverse ETFs, including potential tracking errors, compounding effects, and the need for active management. These ETFs are not suitable for all investors, especially those with a long-term investment horizon.

8. Monitoring and Due Diligence:

• If you intend to invest in leveraged or inverse ETFs, it's crucial to monitor your positions regularly and conduct thorough due diligence. Understand how the daily reset impacts performance and whether the ETF aligns with your investment goals.

Leveraged and inverse ETFs can be powerful tools for experienced investors looking to capitalize on short-term market movements or hedge existing positions. However, they come with a higher level of complexity and risk compared to traditional ETFs. Investors considering these products should have a solid understanding of their mechanics, daily resetting, and potential impact on returns. Consulting with a financial advisor or conducting in-depth research is advisable before investing in such funds.