Comprehensive guide on Leveraged ETF Strategy including investment strategies, risk measures, due diligence, and suitability for investors.

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**Leveraged ETF Strategy**

Leveraged ETFs are designed to achieve returns that are multiples of the performance of the underlying index they track. These funds use leverage, or borrowed capital, to increase their market exposure. Typically, a leveraged ETF uses $2 of leverage for every $1 of investor capital, commonly referred to as 2x or double leverage.

The goal of a leveraged ETF is to generate a return on the borrowed capital that exceeds the cost of acquiring that capital. However, the performance over periods longer than their rebalancing frequency may deviate from the stated leverage due to the path of returns.

For example, consider an ETF designed to deliver double the daily return of a reference asset. If the reference asset’s value steadily increases over the month, the leveraged ETF’s return might exceed double the reference asset’s return. Conversely, if the reference asset follows a volatile path, the leveraged ETF return may be less than double. This phenomenon occurs due to portfolio management strategies inherent in daily leveraged ETFs.

Here’s an illustration:

- You have a leveraged ETF designed to double the daily return of a reference asset.
- If the reference asset increases by 3% from an index value of 100, reaching 103, the ETF’s asset value would rise from $200 to $206 (given $100 of borrowed money).
- The leverage factor would now be less than 2 (Calculate as: $206 / $106 = 1.94).
- To restore the target double leverage, the ETF must increase its leveraged position and borrow more to boost the assets from $206 to $212 (calculate as 2: $212 / $106 = 2).

- Strategies typically aim to buy more positions in the security if its price falls (averaging down).
- With increased position costs, the ETF becomes more exposed, increasing downside vulnerability.
- Repeated compounding in a volatile market can cause deviations from the targeted multiple of holding period returns.

Investors need to predict not only the overall return but also the return path for optimal utilization of leveraged ETFs.

Many alternative mutual funds must comply with regulatory limits concerning derivative use, leverage, short selling, and illiquid securities. These limitations influence the viable strategies for these funds, favoring the use of certain alternative investment strategies. Here are a few categorized by their liquidity and ease of calculating daily NAVs:

- Managed futures/commodities
- Equity market-neutral and long/short equity
- Global macro
- Dedicated short bias
- Merger or risk arbitrage
- Fixed-income arbitrage

- Convertible arbitrage
- High-yield bonds and distressed securities

- Emerging markets
- Private equity and real estate investments

- Absolute risk includes total return variability from all risk sources.
**Standard Deviation**: Measures dispersion around an average return. Monthly figures often annualized via $ ext{annualized standard deviation} = ext{monthly standard deviation} imes ext{sqrt}(12)$.

**Skew**: Tilt toward negative or positive returns. Positive skew favors the right side returns.**Kurtosis**: Measure of return concentration around the average (distribution tails). High kurtosis means extreme returns are more likely.

- Drawdowns, maximum drawdown, and time to recovery.
- Percentage of profitable and losing months.
- Sharpe Ratio: Plan of manipulating the risk/reward ratio via $$ ext{Sharpe Ratio} = rac{R(a) - R(f)}{ ext{SD}(a)}$$

- Background, governance, and risk management frameworks?
- Senior management personal investments in the fund?

- Investment objective and adaptable history?
- Risk management methods?
- Financial leverage?

Main areas include: investment manager experience, compliance culture, compensation methods, and detailed fund structure review.

Alternative strategies have diverse objectives, strategies, and underlying portfolios. Therefore, suitability depends on the following investor characteristics:

- Outstanding portfolio theory knowledge.
- Specific outcome-focused objectives.
- Medium-term investment horizon.
- Short-to-medium term liquidity needs.

Key terms to know:

**Leverage**: Use of borrowed funds to increase the investment size.**Net Asset Value (NAV)**: The value per share of a mutual fund.**Standard Deviation**: A statistical measure of return dispersion.**Sharpe Ratio**: Ratio indicating risk-adjusted returns above a risk-free rate.**Drawdown**: Peak-to-Trough decline in fund value, expressed as percentage losses.**Skew and Kurtosis**: Measures for assessing distribution character of investment returns.

Summarized key points about leveraged ETF strategies, suited alternative mutual fund strategies, performance assessment using risk measures, diligence in alternative investments, and strategic suitability assessments.

- Explain the rebalancing strategy of leveraged ETFs and its implications.
- What measures help appraise downside risk in alternative strategies?
- How does skewness and kurtosis distinction aid in risk analysis?
- What factors should be checked about investment managers during due diligence?

**What is a leveraged ETF?**
A leveraged ETF is a fund that uses financial derivatives and debt to amplify returns on an underlying index.

**Why does a leveraged ETF not always yield exact multiples of the underlying index over extended periods?**
Due to path dependency and daily rebalancing, a leveraged ETF’s performance can deviate from exact multiples during volatile periods.

**Which investors are suitable for alternative mutual funds?**
Those with excellent portfolio theory understanding, medium-term horizons, and specific outcome focuses.

**What tools can investors use for risk-adjusted performance evaluation?**
Tools such as Sharpe ratio, drawdown measures, and skew indexes.

Remember to accurately respond to review questions and FAQs after reading the text. Conduct more examples and learning activities to strengthen understanding of leveraged ETF strategies and alternative investments.

Consider well-preparing for traditional fund vs alternative fund control verification processes through regulatory audit confirmation.

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## What is the primary objective of a leveraged ETF?
- [ ] To provide the exact same return as the underlying index
- [x] To achieve returns that are multiples of the performance of the underlying index it tracks
- [ ] To minimize the use of borrowed capital
- [ ] To eliminate exposure to the underlying index
> **Explanation:** A leveraged ETF aims to achieve returns that are multiples of the underlying index it tracks by using borrowed capital.
## How does a leveraged ETF provide higher exposure to the underlying index?
- [ ] By investing solely in high-yield bonds
- [ ] By eliminating rebalancing needs
- [ ] By doubling the investor's capital solely
- [x] By using borrowed capital in addition to investor capital
> **Explanation:** A leveraged ETF uses borrowed capital in addition to investor capital to provide a higher level of exposure to the underlying index.
## If the reference asset's value increases steadily over a month, what happens to the return of a leveraged ETF designed to double the daily return?
- [x] It provides more than double the return of the reference asset
- [ ] It provides exactly double the return of the reference asset
- [ ] It provides less than double the return of the reference asset
- [ ] It provides a negative return
> **Explanation:** If the reference asset steadily increases over the month, the leveraged ETF would provide more than double the return due to its leverage.
## What happens to a leveraged ETF if the underlying index rises 3% and it's designed to double the daily return?
- [ ] ETF assets rise by less than 3%
- [x] ETF assets rise from $200 to $206
- [ ] ETF assets rise from $100 to $203
- [ ] ETF assets fall due to market volatility
> **Explanation:** A 3% rise on an index value of 100 results in a value of 103. The ETF assets, with $100 of borrowed money, rise from $200 to $206.
## Why does a leveraged ETF need to borrow more funds to restore the leverage factor after an increase?
- [ ] To minimize the risk exposure
- [ ] To decrease net assets
- [x] To maintain the stated leverage ratio
- [ ] To sell off high-risk positions
> **Explanation:** To maintain the leverage factor of 2x, a leveraged ETF must borrow more to adjust for the increased value of its assets.
## Why can a leveraged ETF deviate from double the return over a longer time horizon?
- [ ] Due to rebalancing infrequency
- [ ] Due to changes in investor capital
- [x] Due to compounded volatility and the path of returns
- [ ] Due to portfolio diversification
> **Explanation:** Compounded repeatedly, the leveraged ETF will deviate from double the holding period return in a volatile market due to the path of returns.
## What must investors predict when investing in leveraged ETFs?
- [ ] Only the return of the reference asset
- [x] Both the return and the path of the return of the reference asset
- [ ] The levels of volatility solely
- [ ] The cost of borrowed funds only
> **Explanation:** Investors in leveraged ETFs need to predict not only the return of the reference asset but also the path of the return over time.
## Which of the following is least likely to be used by an alternative mutual fund due to liquidity requirements?
- [ ] Managed futures/commodities
- [ ] Equity market-neutral and long/short equity
- [ ] Fixed-income arbitrage
- [x] Private equity and equity real estate
> **Explanation:** Private equity and equity real estate are the least liquid and therefore least likely to be used due to the requirements to provide daily liquidity and calculate daily NAV.
## Which risk measure gives a good indication of the dispersion of returns?
- [x] Standard deviation
- [ ] Skew
- [ ] Beta
- [ ] Alpha
> **Explanation:** The standard deviation measures how much individual returns deviate from the average return, giving a good indication of return dispersion.
## Why is understanding downside risk important when evaluating alternative strategy funds?
- [x] Because investors are more concerned with downside volatility
- [ ] Because upside volatility is not risky
- [ ] Because it is easier to calculate than standard deviation
- [ ] Because it indicates the fund will never have a loss
> **Explanation:** Downside risk measures are popular because investors are usually more concerned with downside volatility than upside volatility, especially given the absolute return objective of alternative strategy funds.

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Saturday, July 13, 2024