In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

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In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by nisiprius » Thu Sep 05, 2019 12:07 pm

The Vanguard 500 Index Fund declined more than 21% in a single day in 1987. AFAIK there are no ETFs with more than 3X leverage, but 4X ETFs were being prepared for the market a year or so ago (though never approved by the SEC).

This question is purely for my education, on how leveraged and inverse ETFs work, with respect to the derivatives they use.

In our imagination, suppose we have a 5X leveraged S&P 500 ETF, with $10,000 invested in it, and suppose the S&P 500 index drops -25% in a single day. According to the arithmetic, if it were real leverage, the fund shareholder ought to have -$2,500.

What would really happen? Would the actual fund NAV just drop to zero? Or to some very low positive value? With the ETF company shrugging and pointing to disclaimer language, and that's the end of it?

Or is there really a $12,500 loss, and since the shareholder is only losing $10,000, is someone else out the remaining $2,500? And, if so, whom?
Last edited by nisiprius on Thu Sep 05, 2019 3:32 pm, edited 4 times in total.
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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Jags4186 » Thu Sep 05, 2019 12:18 pm

nisiprius wrote:
Thu Sep 05, 2019 12:07 pm
The Vanguard 500 Index Fund declined more than 21% in a single day in 1987. AFAIK there are no ETFs with more than 3X leverage, but 4X ETFs were being prepared for the market a year or so ago (though never approved by the SEC).

This question is purely for my education, on how leveraged and inverse ETFs work, with respect to the derivatives they use.

In our imagination, suppose we have a 5X leveraged S&P 500 ETF, with $10,000 invested in it, and suppose the S&P 500 index drops -25% in a single day. According to the arithmetic, if it were real leverage, the fund shareholder ought to have -$2,500.

What would really happen? Would the actual fund NAV just drop to zero? Or to some very low positive value? With the ETF company shrugging and pointing to disclaimer language, and that's the end of it?

Or is there really a $12,500 loss, and since the shareholder is only losing $10,000, is someone else out the remaining $2,500? And, if so, whom?
If the fund is levered there is borrowed money somewhere in there. I would assume the lender, however convoluted it is to find the lender, is the one taking the bath.

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Re: In theory, in a 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Iridium » Thu Sep 05, 2019 12:18 pm

My understanding of leveraged ETFs is that they are pretty much all ETNs (exchange traded notes). In other words, there is no actual basket of securities, nor real leverage. Instead, you have a structured note, where some bank promises to pay based on change in the index value. That bank would then have its own risk management procedures to largely cancel out its exposure to shifts in the index value.

Which is all a very long way off saying: the ETF would fall to 0. The negative amount would be covered by the issuer of the note, who has most likely already bought options or the like to pass the risk off onto someone else.


Edit: I was wrong. Sorry for the confusion.
Last edited by Iridium on Thu Sep 05, 2019 9:21 pm, edited 1 time in total.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by alex_686 » Thu Sep 05, 2019 12:19 pm

I would imagine that the fund or the fund’s lending counter-party would start liquidating once intraday trading hit -10%. The fund is a limited liability corporation with clearly defined assets. Nobody is going to rescue them unless the are something like the Long Term Capital Management hedge fund. Because the equity holders would go to zero and the fund’s lending party would have to eat the negative equity & debts of the firm.

So hopefully the fund would end with a low value. However liquidating leveraged positions in a down mark can be impossible.
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Re: In theory, in a 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by alex_686 » Thu Sep 05, 2019 12:23 pm

Iridium wrote:
Thu Sep 05, 2019 12:18 pm
My understanding of leveraged ETFs is that they are pretty much all ETNs (exchange traded notes). In other words, there is no actual basket of securities, nor real leverage.
IIRC, most hold futures - so actually securities with actually leverage. The ETN designation is driven by tax and diversification considerations.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by jdilla1107 » Thu Sep 05, 2019 12:31 pm

Note that equity exchanges have circuit breakers now that would not allow a drop larger than 20% in one day. Here are the different circuit breakers.

https://personal.vanguard.com/us/conten ... ersJSP.jsp

So, you would just lose all your equity at the end of the day. Whoever is the counterparty of the fund would be responsible for liquidating at their terms, most likely.

I think the SEC has specifically not allowed bigger daily ETFs for this reason. Otherwise you know someone would come up with the 10x.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by fallingeggs » Thu Sep 05, 2019 12:44 pm

This, among other reasons, why exactly why such a vehicle doesn't exist and will never be approved by the SEC. Investment banks allow extreme levels of leverage on intraday trades, but only when they are allowed to liquidate positions during the day as such positions reach wipe out levels. ETFs can use 3 times leverage because the stock markets begin to actually shut down for the day when losses approach 20%, so hitting a 34% loss in a single day on the S&P (or any major index that has a 3 times leverage ETF referencing it) would be practically all but impossible to happen. The SEC and the investment banks know this.

But if an ETF were to actually go negative, the investment banks would be on the hook as the ETF is bankruptcy remote, so neither the ETF sponsor or investors would have to pony up. The sponsor (iShares, Proshares, etc.) might chose to pay the investment bank to retain their reputation or else they'll never get their business again.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by rascott » Thu Sep 05, 2019 12:45 pm

jdilla1107 wrote:
Thu Sep 05, 2019 12:31 pm
Note that equity exchanges have circuit breakers now that would not allow a drop larger than 20% in one day. Here are the different circuit breakers.

https://personal.vanguard.com/us/conten ... ersJSP.jsp

So, you would just lose all your equity at the end of the day. Whoever is the counterparty of the fund would be responsible for liquidating at their terms, most likely.

I think the SEC has specifically not allowed bigger daily ETFs for this reason. Otherwise you know someone would come up with the 10x.
Exactly....3x is all that's been approved.. and with the daily circuit breakers the 3x with daily reset could technically never go to absolute 0.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Random Musings » Thu Sep 05, 2019 1:37 pm

Simply put, if long, you would be a hurting pup.

Academic theory wouldn't mean much as that time for a 5X holder, let alone a 3X. But a few bottles of liquor might dull the pain in the short term...….

I believe that leading up to the 29 depression, that margin was 10%, and we saw what happened there. This is just another social experiment, with slightly less leverage.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by nisiprius » Thu Sep 05, 2019 2:09 pm

Shame on me for saying "ETF" instead of "ETN." I'll edit my initial post accordingly. And now back to "ETF" again, see HEDGEFUNDIE's posts below.

Synthesizing, then: the stock market rules are intended to prevent such a fall from happening, so it's "impossible," and the SEC would never allow an ETF with so much leverage that it would be possible.

But, if it happened, someone on the ETN side would see it coming and start liquidating early, intraday. The result is that if the base index fell -25%, the actual asset sales would have been made, some at -10%, some at -15%, etc. and the actual assets held somewhere by someone might get sold at an average loss of less than -20%.

So, instead of falling -125%, in reality the assets held... somewhere, by someone... would probably lose less than -100%. Let's say, -90%.

Depending on other details, maybe the ETN would share that skillful management with shareholders and the ETF would only lose -90%, Or, the ETN would fall to zero... get liquidated... and the ETN operators might even walk away with a profit, the difference between the 100% loss experienced by their shareholders and the 90% loss they experienced themselves.

Something like that?
Last edited by nisiprius on Thu Sep 05, 2019 3:30 pm, edited 1 time in total.
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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by senex » Thu Sep 05, 2019 2:53 pm

nisiprius wrote:
Thu Sep 05, 2019 2:09 pm
Synthesizing, then: the stock market rules are intended to prevent such a fall from happening, so it's "impossible," and the SEC would never allow an ETF with so much leverage that it would be possible.
Not quite true, for a few reasons:
(a) 3x levered etfs/etns existed before individual-stock automatic circuit breakers.
(b) automatic circuit breakers exist for US equities and some other assets, but not everything on earth; a levered etf tracking a non-US-equity basket is not guaranteed to have a circuit breaker supporting its index
(c) SEC allows inverse levered etfs/etns, and since there is no pause when stocks go up 100%, a -1x (negative 1x) levered product could go to zero.

When levered products get close to zero nav lots of weird stuff happens. Matt Levine's summary of the XIV debacle is a good introduction: https://www.bloomberg.com/opinion/artic ... ost-worked
(XIV is an inverse etf that lost 94% of its value on one day last year).

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by nisiprius » Thu Sep 05, 2019 3:04 pm

senex wrote:
Thu Sep 05, 2019 2:53 pm
...When levered products get close to zero nav lots of weird stuff happens. Matt Levine's summary of the XIV debacle is a good introduction: https://www.bloomberg.com/opinion/artic ... ost-worked...
(XIV is an inverse etf that lost 94% of its value on one day last year).
Matt Levine wrote:That is, you were right that volatility would go down. You were wrong to buy XIV to express that view.
Heard that one before. When "commodities" ETNs were issued, people who were sure the price of oil would go up bought OIL and USO to express that view, and oil went up, but their ETNs didn't. Completely different explanation, though.
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Re: In an (imaginary!) 5X leveraged ETN what would happen if the base index fell more than 20% in a single day?

Post by HEDGEFUNDIE » Thu Sep 05, 2019 3:09 pm

ETFs and ETNs are not synonymous, and we are mostly taking about ETFs here, not ETNs.

The 3x instruments we talk about most around here are ETFs. There are leveraged ETNs but they are less common.

ETFs give the investor recourse to the underlying securities if the securities house (e.g. ProShares) goes bankrupt.

ETNs are purely a bet with the securities house, no recourse if things go wrong.
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Re: In theory, in a 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by HEDGEFUNDIE » Thu Sep 05, 2019 3:10 pm

Iridium wrote:
Thu Sep 05, 2019 12:18 pm
My understanding of leveraged ETFs is that they are pretty much all ETNs (exchange traded notes). In other words, there is no actual basket of securities, nor real leverage. Instead, you have a structured note, where some bank promises to pay based on change in the index value. That bank would then have its own risk management procedures to largely cancel out its exposure to shifts in the index value.
This is incorrect. Look at the holdings of UPRO or TMF. There are real instruments in there.

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Re: In an (imaginary!) 5X leveraged ETN what would happen if the base index fell more than 20% in a single day?

Post by nisiprius » Thu Sep 05, 2019 3:46 pm

HEDGEFUNDIE wrote:
Thu Sep 05, 2019 3:09 pm
ETFs and ETNs are not synonymous, and we are mostly taking about ETFs here, not ETNs.
Changed my initial post back. :D
Look at the holdings of UPRO or TMF. There are real instruments in there.
URPO holdings. Indeed. 505 holdings of stocks. If I downloaded into a spreadsheet and totaled correctly:

As of 9/14/2019
505 stocks, $931,823,719.03
Net other assets/cash, $289,844,878.08
Swaps ("S&P 500 Index Swap," "SPDR S&P 500 (SPY SWAP)"), "Exposure value, notional + G/L" : 2,732,373,596.26

The factsheet lists the "net assets" for 6/30/19 at $1.33 billion, which is... roughly equal stocks + "other assets/cash."
And the swaps, which for some reason are listed without dollar signs, are roughly twice that number.
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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by ohai » Thu Sep 05, 2019 4:10 pm

Ok. So UPRO is a fund, not a Note like VXY or something, they hold SPX stocks, some collateral, and TRS and other derivatives to create leverage. In that case, it certainly seems like NAV can become negative if the market gaps down 50% in one day.

I don't know who will be on the hook for negative value in such a scenario. There is precedent for hedge funds going negative and calling clients for more money, but the sponsor company of UPRO might have to absorb some or all losses - it doesn't seem possible to collect money from all the small retail ownders.

I suppose it will be described in the prospectus.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by HEDGEFUNDIE » Thu Sep 05, 2019 4:23 pm

Don’t forget that every leveraged fund has an inverse counterpart.

This is not a coincidence.

A 5x leveraged fund dropping 100% would be at least partly balanced by its 5x inverse fund counterpart rising 100%. The counterparties are the same across the inverse and the leveraged funds. So at the end of the day, it’s not UPRO having to pay BAML or Credit Suisse 100%, rather it’s the net impact across the funds that matters. To the extent that the AUMs between the two funds don’t exactly match, the funds also hold cash as further collateral.
Last edited by HEDGEFUNDIE on Thu Sep 05, 2019 4:27 pm, edited 3 times in total.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Call_Me_Op » Thu Sep 05, 2019 4:25 pm

Nisi,

Funny that you asked this question. It popped into my head just a couple of days ago, but I never got around to asking it.
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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by nisiprius » Thu Sep 05, 2019 5:22 pm

HEDGEFUNDIE wrote:
Thu Sep 05, 2019 4:23 pm
Don’t forget that every leveraged fund has an inverse counterpart.

This is not a coincidence.

A 5x leveraged fund dropping 100% would be at least partly balanced by its 5x inverse fund counterpart rising 100%. The counterparties are the same across the inverse and the leveraged funds. So at the end of the day, it’s not UPRO having to pay BAML or Credit Suisse 100%, rather it’s the net impact across the funds that matters. To the extent that the AUMs between the two funds don’t exactly match, the funds also hold cash as further collateral.
Interesting.

UPRO assets, $1.33 billion.
SPXU, -3X S&P 500 ETF assets... $549.81 million.

OK, so not all that well balanced, but I see that to some extent, to $550 million, ProShares is just acting like a bookmaker, managing investors who are betting against each other.
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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by psteinx » Thu Sep 05, 2019 6:14 pm

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Oicuryy » Thu Sep 05, 2019 7:16 pm

nisiprius wrote:
Thu Sep 05, 2019 3:46 pm
And the swaps, which for some reason are listed without dollar signs, are roughly twice that number.
So the swap notional of a 3x fund is twice the funds assets. If the index falls 50% the fund will have to pay all its assets to the swap counterparty.

Presumably the swap notional of a 5X fund is four times the funds assets. It would take a 25% drop in the index to wipe out the funds assets.

Have I got that right?

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by alex_686 » Thu Sep 05, 2019 7:18 pm

nisiprius wrote:
Thu Sep 05, 2019 2:09 pm
.. and the ETN operators might even walk away with a profit, the difference between the 100% loss experienced by their shareholders and the 90% loss they experienced themselves.
No. The operators get paid based on AUM. It does not matter if the fund goes to 0 or -10%. They close up shop. The don’t pick up the liabilities of the fund. This is basically true if the fund drops by 90% - they will be closing up shop.


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Re: In theory, in a 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Iridium » Thu Sep 05, 2019 9:15 pm

HEDGEFUNDIE wrote:
Thu Sep 05, 2019 3:10 pm
Iridium wrote:
Thu Sep 05, 2019 12:18 pm
My understanding of leveraged ETFs is that they are pretty much all ETNs (exchange traded notes). In other words, there is no actual basket of securities, nor real leverage. Instead, you have a structured note, where some bank promises to pay based on change in the index value. That bank would then have its own risk management procedures to largely cancel out its exposure to shifts in the index value.
This is incorrect. Look at the holdings of UPRO or TMF. There are real instruments in there.
I stand corrected. Thank you.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by senex » Fri Sep 06, 2019 8:54 am

Oicuryy wrote:
Thu Sep 05, 2019 7:16 pm
So the swap notional of a 3x fund is twice the funds assets. If the index falls 50% the fund will have to pay all its assets to the swap counterparty.

Presumably the swap notional of a 5X fund is four times the funds assets. It would take a 25% drop in the index to wipe out the funds assets.

Have I got that right?
Not quite. If an index falls 33% the 3x fund is wiped out. If index falls 20% the 5x is wiped out.

You might be forgetting that the assets themselves have dropped in value in addition to the swaps.
i.e. A 3x fund starts day with $1M stocks + $2M swap exposure.
Market falls 33%.
Stocks are now worth $667k.
You contractually owe the swap counterparty $667k (33% of $2M notional).
Counterparty takes all your assets and cancels the swap contract (for having no more collateral or whatever)(*)

(*) I don't know the actual mechanics of the contract. I'm just assuming the contracts are written such that they cease to exist once a counterparty has no collateral and no ability to pay for further moves against them, similar to the "closing you out" concept in futures or margin trading.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by Oicuryy » Fri Sep 06, 2019 10:15 am

senex wrote:
Fri Sep 06, 2019 8:54 am
You might be forgetting that the assets themselves have dropped in value in addition to the swaps.
You're right, I did forget that.

nisiprius wrote:
Thu Sep 05, 2019 12:07 pm
Or is there really a $12,500 loss, and since the shareholder is only losing $10,000, is someone else out the remaining $2,500? And, if so, whom?
If I understand what I've learned in this thread... The 5X fund starts with 10k in assets and a swap contract with 40k notional value. The index drops 25%. The fund then has 7.5k in assets and owes the swap counterparty 10k. The counterparty gets the 7.5k in assets and eats the 2.5k loss. The fund closes and the shareholders get nothing.

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Re: In an (imaginary!) 5X leveraged ETF what would happen if the base index fell more than 20% in a single day?

Post by senex » Fri Sep 06, 2019 10:45 am

Oicuryy wrote:
Fri Sep 06, 2019 10:15 am
If I understand what I've learned in this thread... The 5X fund starts with 10k in assets and a swap contract with 40k notional value. The index drops 25%. The fund then has 7.5k in assets and owes the swap counterparty 10k. The counterparty gets the 7.5k in assets and eats the 2.5k loss. The fund closes and the shareholders get nothing.
That's pretty darn close.

It's possible the counterparty could avoid eating the loss -- for instance, with a contract provision that the swap is invalidated and collateral is seized at a certain level. Say the index falls 20%, the provision triggers, everything is liquidated, and no one "loses" any additional money as the index drops the additional 5% (because all has been liquidated).

If the market dropped too fast for the counterparty to react/hedge/etc, then yes, I think they would eat the loss.

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