Short and Leveraged ETPs are designed around the daily performance of their underlying asset and are intended to be traded intraday. They have a fixed level of leverage (-3x, +3x, etc.) which makes it easy to determine how the price of a Short and Leveraged ETP will move during a single trading day, which is simply the leverage factor times the daily performance of the underlying benchmark.

Investors may hold Short and Leveraged ETPs for longer than one day; however, the cumulative returns could be larger or smaller than the leverage factor implies. This is because the ETPs are “reset” at the end of each trading day.

The daily resets of leveraged ETPs cause a compounding effect, which means that the gains or losses from one period affect the base from which the next period’s returns are calculated. As the base increases or decreases, the leveraged return also gets larger or smaller in each subsequent period. Therefore, the return for any given period will depend on both the percentage gain/loss for that period, plus any cumulative gain/loss on the initial investment.

Compounding can have both positive and negative effects and investor considering holding leveraged ETPs for extended periods is important to fully understand that there could be a significant difference between the ETP performance, and the benchmark performance multiplied by the leverage factor.

The compounding effect can positively enhance returns in trending markets (upward or downward) whilst negatively impacting returns when the markets are more volatile or choppy.

Daily returns in an up-trending market

Let’s have a look at an example which show the cumulative performance of an underlying asset which rises 5% every day, for ten days in a row, and a 3x Leveraged ETP, which delivers 3x the daily return of the underlying instrument.

• The underlying asset rises 5% each day for 10 consecutive days.

• Investors may expect that the ten-day return would produce 3x the cumulative return of the underlying i.e., 189% (3 x 63%), while the cumulative return of the ETP is 305%, as the compounding effect has outperformed the sum of the daily returns.

Daily returns in a down-trending market

Let’s have a look at an example which show the cumulative performance of an underlying asset which falls 5% every day, for ten consecutive days, and a 3x Leveraged ETP, which delivers 3x the daily return of the underlying instrument.

• The underlying asset value falls by 5% for ten days in a row.

• The 3x Leveraged ETP falls 15% each day.

• Investors may expect that on day 8 the 3x Leveraged ETP would lose its entire value (-100%), while the cumulative return of the ETP for the ten-day period is -80%, as the compounding effect has outperformed the sum of negative daily returns.

Daily returns in a volatile market

Let’s have a look at an example which show the cumulative performance of an underlying asset which rises and falls by 5% continuously, for ten consecutive days, and a 3x Leveraged ETP, which delivers 3x the daily return of the underlying instrument.

• The underlying asset value rises 5% on day one, then falls by 5% on day two, and so on.

• The 3x Leveraged ETP rises 15% on day one, then falls by 15% on day two, and so on.

• Investors may expect that the ten-day return would produce 3x the cumulative return of the index i.e. – 3.73% (3 x -1.24%), while the cumulative return of the ETP is -11%, as the compounding effect has underperformed the sum of daily returns.

In conclusion:

The key factors of compounding are:

• Investment returns for periods longer than one day are affected by compounding

• Daily compounding can have either a positive or negative effect on returns

• For periods longer than one day, daily compounded returns may not be equal to an unleveraged return (or the benchmark index) multiplied by the leverage factor

• A trending market (upwards or downwards) will result in returns which appear to “outperform”

• High volatility or a sideways trending market will result in returns which appear to “underperform”

• The compounding effect increases with higher volatility, greater leverage and longer holding periods