7 things to remember when investing in Short and Leveraged ETPs
1. Short and Leveraged ETPs follow a recipe for returns strictly
Short and Leveraged ETPs (S&L ETPs) are complex instruments that can bear high risk. They must be structured in a very specific way to be able to provide the short or leveraged returns that investors expect.
ETP are generally structured around an index. That index represents the performance of the underlying assets in a packaged, easier to follow format. In most market conditions, the price (or “Fair Value”) of an ETP at a given point in time is inferred from:
The performance of its underlying index between the last point in time at which the ETP Price per Security (also known as “Net Asset Value” or “NAV”) was calculated and the current point in time multiplied by its leverage ( i.e. a number as defined in the name of the ETP and called the “Leverage Factor”) minus fees and costs.
In most circumstances, the ETP’s Fair Value can then be calculated with a simple formula below.
Sometimes that index is unleveraged and therefore the Leverage Factor is NOT 1 (it is above 1 for leveraged ETPs and below 0 for short ETPs), sometimes the index includes the leverage itself and therefore the leverage Factor is 1.
What is fundamental to remember is that the Net Asset Value is the only reference price which will precisely provide the relationship between the underlying index’s performance and the ETP’s performance. So, when comparing the performance of the ETP to its underlying index, the previous Net Asset Value must be used as reference point. If we were to pick two random times during the day and compare the performance of the ETP and the performance of the underlying index between those two points in time, there would be no observable relationship because they don’t reference the NAV.
Figure 2: Typical Trading System Front end view
So what is the Net Asset Value? It is the per unit price of the ETP calculated at a given point in time every business day (usually the end of the trading day based on the market prices of the ETP’s underlying assets, known as the “NAV Calculation Time”). At the NAV Calculation Time, the ETP’s NAV and the ETP’s Fair Value are equal.
More Information on NAV Calculation Time in “Closing Price and Net Asset Value are not the same thing” below.
2. S&L ETPs may not always track what you think they track
An ETP’s performance is intimately linked to the performance of its underlying index, as described above. In turn, the performance of the underlying index is intimately linked to the performance of the underlying asset. It is therefore crucial to understand what this underlying asset is. What is that underlying asset?
For Equity, the underlying asset is NOT the index that we can see on dedicated financial markets TV all day long (which is usually the Price Index). The underlying asset of the ETP is, most often than not, a total return index that include dividends. Both price indices and total return indices follow the same basket of stocks, but their performance is different. What this means is that an investor in a long leveraged ETP will receive the daily performance of the stock inclusive of all the dividends paid up to that point in time. An investor in a short ETP will pay the performance of the stock and will pay the dividends as well. In some cases, the underlying asset is the Equity Index Future i.e. the obligation to buy or sell the basket of stocks that the index represent at some point in the more or less distant future.
For Currency, the underlying asset is not the Exchange Rate Spot that we can see on Google or any other website, it is the next day FX Forward i.e. the obligation to exchange a currency against another in the future. The Spot Price and the Forward Price move in a very similar fashion but are not exactly the same. Trying to calculate the fair value of an ETP using the performance of the Spot Price would not work.
For Commodity, the underlying asset is NOT the commodity itself (known Spot), it is the Commodity Future i.e. the obligation to buy or sell the commodity at some point in the more or less distant future. Similarly, to currencies, the commodity Spot Price and the commodity Future Price move in similar fashion but not exactly and mistaking one for the other would create some inconsistency in the calculation of the ETP’s performance.
For Fixed Income, the underlying asset is NOT a bond, it is the bond Future price i.e. the obligation to buy or sell the a given Bond at some point in the more or less distant future.
For VIX, the underlying asset is NOT the level of VIX itself. The underlying asset of the ETP is a basket of Short Term Futures on the VIX i.e. a basket of obligation to exchange the level of the VIX index versus the level of realized volatility in the S&P 500 at a few different points in the future.
3. Closing Price and Net Asset Value are not the same thing
ETPs are exchange traded instruments and therefore they can be bought and sold on exchange. However, because WisdomTree ETPs are aimed at European investors, they can only be traded on European stock exchanges. Such exchanges are open during the day, usually from around 8 or 9AM to 3 or 4PM European time. Therefore, WisdomTree ETPs can only be traded between those times.
When European markets are opened, the quoted ETP prices will be reflecting the fair value of the ETP. When the underlying asset moves, that move is simultaneously mirrored in the fair value (as highlighted before) and in the quoted price of the ETP as well.
At the end of the day, when the European stock exchanges close, the closing price on the exchange is derived from the last traded price (“Closing Price”) in the product whenever that trade happen (i.e. this could be 5 seconds before the close or 5 hours before the close). Therefore, the Closing Price and the Fair Value of the ETP at the time the exchange closed, for the SAME day can be very different.
As discussed earlier the NAV Calculation Time (a time defined in the prospectus) is linked to the point in time when the underlying assets are valued for their end of day and NOT to the point in time when the ETP was last traded on exchange. In many cases, the NAV Calculation Time does NOT match the closing time of the European exchanges. Taking the example of a WTI Crude Oil ETP, the NAV is calculated when the New York Stock Exchange, on which WTI Crude Oil Future is traded, closes at 14:30 EST (Eastern Standard Time) which is significantly later than when European exchange closes.
That means as well that the Closing Price and the NAV of the ETP for the SAME day can be very different. It is also worth mentioning here that the NAV is not a price that can be traded directly on the markets. The only price available to investors are quoted prices by Market Makers. They make come close, if the NAV Calculation Time happens during European market hours but the NAV itself is a reference point and is not tradable.
4. Money does not sleep but European Exchanges do
As highlighted above WisdomTree S&L ETPs are traded on European stock exchanges only. On the contrary, their underlying assets may not live on European exchanges only. Assets like the US Dollar, or Oil Barrels are traded around the clock and around the globe. When European exchanges close, traders move to the next one and so on. Going from Europe to America to Asia and back again. Trading in underlying assets may continue following the news and the actions of the traders around the world on a 24-hour basis. When the European stock exchanges do open again, the price of those underlying assets may have evolved and moved, sometimes significantly.
Figure 3: ETP Fair Value and ETP Quoted Price around the clock
During the period between the close of the European Exchange and its reopening the next morning it is not possible to trade the ETP. However, the ETP fair value will continue to change in tandem with the price of the underlying (being the US Dollar, Oil or Gold) even if no trading has been happening on the ETP itself and so the quoted price when the European markets close on one day and the quoted price when they reopen the next day can vary significantly. The only way to prevent against this is to sell the ETP at the end of market hours and reinvest the next morning. It is worth noting that the quoted price in European stock markets when they reopen will not be equal to the NAV. This quoted price will reflect the fair value of the ETP at that point in time which in turn will reflect the price of the underlying asset at that point in time (i.e. NOT at the NAV Calculation Time yesterday).
5. S&L ETPs are also exposed to Currency
WisdomTree ETPs can be traded in multiple currencies. In a lot of cases, European investors may trade the ETP in Euros by investing in the Euro trading line of the ETP. However, the underlying asset may not be trading in Euro. Gold or Oil Futures, for example, are denominated in US Dollars and therefore the base currency and Net Asset Value of the ETP is calculated in US Dollars. This difference will create noise in the relationship between the performance of the underlying asset and the performance of the ETP. Taking an example of a 3x daily leveraged Oil ETP, if between one NAV and the next, Oil is up 1% in US Dollars. The ETP’s NAV will be up 3% minus fees and costs in US Dollars. However, if during the same period the Euro is down 10% versus the US Dollar, a Euro investor in the ETP will also be impacted by that move and overall will be down a bit more than -7% (up 3% thanks to oil and down around 10.3% due to the Euro).
6. Beware of Compounding
Each business day, i.e. from one NAV Calculation Time to the next, the recipe of the ETP applies, with the performance of the ETP being linked to the performance of the underlying asset. However, when considering multiple days in a row, there is a Compounding effect which must be taken into account. In a nutshell, at the end of each day, when the NAV is struck, the reference point for the calculation of performance has changed. It is no longer the NAV from the day before, but it is now the new NAV (as impacted by changes in the underlying).
Taking the example of a 2x leveraged ETP with a starting NAV of 100.
On day 1 The reference point is 100. At the end of the day the underlying asset is up 5%, so the ETP is up 10% (forgetting for the moment the impact of fees and costs).The new NAV is therefore equal to 100*(1+2*5%) = 110.
On day 2 The new NAV is now the new reference point. At the end of the day with a 5% performance of the underlying asset, the new NAV is equal to 110*(1+2*5%) =121
On Day 3 The reference point is again the new NAV i.e.121. And so on every day for ever.
Figure 4: The Compounding Effect
It is worth noting that over the 2 days the underlying asset is up 10.25%. but the ETP is NOT up 20.5%!! It is up 21%. The compounding effect has added 0.5% performance in this case. In other scenario, it could have removed performance.
Over long period of times, the compounding effect would distort the performance even further which is why the recommended holding periods for WisdomTree S&L ETPs is one day only. Investors planning to hold these products for periods longer than their reset frequency will be affected by compounding. As markets go up or down, compounding can have positive or negative effects, which are dependent on the performance of the underlying Index between NAVs. For example:
+ If the market is stable and trending in favour of the investor, then compounding will have generally a positive effect and further increase the performance + If the market is stable but trending against the investor, then compounding will generally have a positive effect and slightly improve the performance + If the market is volatile and characterised by sharp up- and down-movements, then compounding will have a negative effect and the performance of the ETP will be worth less than could have been expected without the compounding effect.
The higher the volatility in the underlying asset, the higher the compounding effect. It will be particularly severe when the market alternates between going up and down daily.
For more details on this complex mechanism and tools explaining how compounding workssee here
7. Restrikes
Using leverage magnifies returns, both on the upside and the downside. Adverse price movements intraday or overnight can quickly and significantly reduce the value of a leveraged ETP sometimes to zero. In periods of high volatility or high stress in the market, the daily returns of the underlying markets are greater and could result in a move that wipes out the value of a short or leveraged product.
To mitigate some of this risk, some (but not all) S&L ETPs include some safety mechanisms such as an intra-day Restrike, an overnight Restrike. ETPs won’t have all those mechanisms included in their structure, some will have two some will have zero. Investors should investigate which mechanism is relevant for each ETP before investing.
The intra-day Restrike is an event where the ETP will reset, between one NAV Calculation Time and the next, if a certain threshold percentage fall in value of the underlying index is met. For example, a daily 2x (double leveraged) ETP might have a safety reset trigger if the underlying index falls by 25% (i.e. where a decline of 50% in the theoretical ETP fair value would have occurred). Once this threshold is reached, the NAV of the ETP resets and continues for the rest of the period using the new reference intraday NAV point (to replace the previous NAV). It is worth noting that the reset is a process which takes some time, usually around 15 minutes. This process starts when the underlying index falls by the threshold amount but in cases were the underlying asset continues to fall, the restrike may conclude with a new reference point significantly lower than the threshold itself. In some cases, the reset may not have time to conclude before the underlying index falls so far that the full value of the ETP is wiped out and the ETP therefore terminates.
The overnight Restrike is similar to the intra-day reset with the important difference that it happens at times where the underlying markets is usually less liquid and therefore the length of the reset period can be longer and the likelihood of the reset failing, and the product terminating with little to no value left, is higher.
If an extreme movement in the underlying asset happens and if the ETP does not have a Restrike feature available at that point in time (for example it is outside of the applicable hours for the Intra-day Restrike and the S&P ETP does not have an Overnight Restrike), it could lead to the swap provider terminating the product at 0 or little value.
Although ETPs can never lose more than the value of the initial investment, the stop loss or intraday reset is designed to try to slow the rate of loss during periods of extreme market movement and prevent the product falling to a value of zero. If the Restrike is successful and the adverse price movements continue, then the investor will not suffer a loss to the same extent as if the Restrike had not occurred. This will create a tapering effect on sustained losses. However, investors may not fully benefit from a ‘rebound’ in the market, as any recovery gains will be applied to a smaller base value. In extreme scenarios, if the underlying asset’s move is so adverse that it brings the ETP’s fair value to zero or negative, in most cases, the S&L ETPs is terminated with a zero value and even if the underlying asset subsequently rebounds, the entirety of the investment is still lost.
Short & Leveraged Exchange-Traded Products are only intended for investors who understand the risks involved in investing in a product with short and/or leveraged exposure and who intend to invest on a short-term basis. Any investment in short and/or leveraged products should be monitored on a regular basis (as frequently as daily) to ensure consistency with your investment strategy. You should understand that investments in short and/or leveraged exchange-traded products held for a period of longer than one day may not provide returns equivalent to the return from the relevant unleveraged investment multiplied by the relevant leverage factor. Potential losses in short and/or leveraged exchange-traded products may be magnified in comparison to investments that do not incorporate these strategies. Please refer to the section entitled “Risk Factors” in the relevant prospectus for further details of these and other risks associated with an investment in short and/or leveraged exchange-traded products. You should consult an independent investment adviser prior to making an investment in short and/or leveraged exchange-traded products in order to determine suitability to your circumstances.
