I came across an interesting article today highlighting how Direxion, who brought us leveraged ETFs providing up to 3X the daily return of various sectors, indices and commodities (see this list of all Leveraged ETF Ticker Symbols for both 2X and 3X daily returns) is changing some of their mutual funds from a daily return of 2X to a Monthly return of 2X, with some to become 2.5X.

Daily, Monthly, What's the Difference?

What this will do for retail investors is to deliver returns that are much more aligned with what many of them think they're supposed to get. When someone sees a 2X return ETF and doesn't read the prospectus or understand the nuances of daily rebalancing, they may expect a return of ~50% at the end of a time period where the underlying index rose 25%. Well, what do you think they do when they find out that they actually LOST MONEY even though they were in a long 2X leveraged fund where the underlying moved in a positive direction? They freak out! While this may not be intuitive, it is completely explained in my article on Leveraged ETF Risks due the mathematical certainty of erosion of share price over time when rebalancing daily. The article there demonstrates how both the Long AND the Short sector funds lost money in the same year during a flat performance for the underlying index.

By performing monthly rebalancing instead of daily rebalancing, the "perceived" tracking error (I don't consider what occurs to be true tracking error because the error is actually on the part of investors who don't know what they're buying, not the fund) will be largely removed. Over a period of 6 months, if the S&P500 gains 10% and you're in a 2.5X monthly rebalance mutual fund, you will likely see something much closer to 25%.

Since they're mutual funds, there are fees and time lags associated with transactions and perhaps that's a good thing too. If you're stuck holding a daily rebalancing mutual fund, chances are you're not doing yourself a favor since daily rebalancing ETFs are trades, not investments. However, with a monthly rebalance, the erosion will be marginalized and you could see the 50% + returns in mutual fund performance that you don't tend to get anywhere else.

Cake and Eat it Too!

For investors seeking the rapid trading benefits of daily leveraged ETFs, they can continue to trade the 2X and 3X ETFs. They can even trade options on these already leveraged instruments. For longer term investors who want the benefit of leveraged returns, but in a buy and hold fashion, they can rely on the monthly rebalanced mutual funds. Note that due to the mere involvement of "rebalancing", there will still be NAV erosion in the monthly funds, but again, it will be much smaller than what we see in the ETFs.