To be honest, I am an investment junkie. Although I have retired from managing other people’s money, investing is my passion, and I am constantly on the lookout for new investment funds and ideas. Recently, a new fund caught my eye: the MAX S&P 500 4X Leveraged ETN (NYSEARCA:XXXX).
As its name implies, the XXXX ETN provides 4x daily leverage to the S&P 500 Total Return Index. Due to its extreme leverage, investors in the XXXX ETN can experience some pretty dramatic performances, both positive and negative.
The S&P 500 Index is currently very overbought with investor sentiment in ‘extreme greed’ territory, so I would personally not commit new capital to leveraged investments like XXXX.
The MAX S&P 500 4X Leveraged ETN is an exchange traded note (ETN) that is issued by the Bank of Montreal (BMO) with the promise of delivering four times the daily returns of the S&P 500 Total Return Index.
What Is An ETN?
Readers may not be familiar with ETNs, as they are relatively less common than exchange traded funds (ETF). An ETN is an unsecured debt security issued by an investment bank (in the case of XXXX, the issuer is BMO) that tracks an underlying index and trade on a major stock exchange like a stock. At maturity, the ETN will pay the return of the index it tracks, less any fees.
In the case of XXXX, those fees can be quite substantial. First, the ETN charges a 0.95% per annum ‘daily investor fee’ that is accrued daily. Furthermore, as compensation for providing leverage to investors, the issuer charges a ‘daily financing rate’ of Prime + 2.0% on the leverage utilized, also accrued daily (Figure 1).
Unlike ETFs, ETNs do not own the underlying portfolio of securities. Instead, an ETN simply provides investors with returns of the underlying index. As a result, investors in ETNs are exposed to the risk that the issuer may default and not honour the contractual total return payout, although this risk is typically very small.
Investors interested in leveraged funds like the XXXX ETN should read and understand the key risks from MAX ETN’s website, as well as consult these warnings from FINRA and the SEC.
Returns Will Have Tracking Error Beyond One Day Horizon
As noted above, The XXXX is an ETN so it does not actually hold the S&P 500 Total Return Index or the underlying stocks. Instead, the value of the ETN is calculated daily using a complex formula that accounts for daily returns of the S&P 500 Total Return Index less daily management fees and daily financing fees.
The main thing to understand with leveraged funds like the XXXX ETN is that they have ‘positive convexity’, but suffer from ‘volatility decay’.
Positive convexity refers to the fact that exposure in the XXXX ETN grows exponentially as price moves in favour of the fund due to compounding. For example, assuming the S&P 500 Index returns 1% every day, then after 22 days, the XXXX ETN’s indicative value will increase to $58.14, or a total return of 132.6% (Figure 2). This is greater than four times the 1% daily compounded return over 22 days of 24.5% or 97.9%.
On the other hand, if we assume the S&P 500 Total Return Index enters a very volatile period where it rises and falls by 3% on alternate days. After the same 22 days, the XXXX ETN’s indicative value will fall to $20.89, or a loss of 16.4%, far more than four times the theoretical loss over 22 days of 1.0% or 4.0% (Figure 3). This decline is due to volatility decay, which occurs because of the daily rebalancing of the fund’s exposure.
Since Inception Returns Have Been Strong…
Since inception, the XXXX ETN has delivered very strong returns of 37.7%, compared to the S&P 500 Total Index’s return of 10.3% over the same period, or roughly 3.7x the underlying indice’s total return (Figure 4).
…But Beware Steep Drawdowns
However, investors are cautioned against projecting from this short performance record, as equity markets have been essentially up in a straight line in the past few months.
If equity markets enter a period of volatility or experience several consecutive down days, then the XXXX ETN can lose value very quickly. For example, assuming the S&P 500 Total Return Index loses 3% per day for 5 days, using XXXX’s scenario analysis, the ETN’s indicative value fall to $13.13, or a loss of 47.5% (Figure 5).
In fact, if we use the financing assumptions used by MAX, but substitute the actual performance of the S&P 500 Total Return Index from 2022, we find that the XXXX would have lost an eye-watering -74.8% compared to -18.1% for the S&P 500 Total Return Index (Figure 6).
Other Risks To Consider
In addition to compounding and volatility decay risks mentioned above, there are other features investors should consider before investing in the XXXX ETN. For example, assuming there is a market dislocation where the S&P 500 Total Return moves by a large percentage intraday, investors buying the XXXX ETN may be subject to increased/decreased leverage, since the actual leverage is calculated based on the prior day’s indicative value.
For example, if the market falls 5% intraday, investors purchasing the ETN may actually have 4.75x effective leverage instead of the 4x indicative leverage (Figure 7).
Another risk to consider is volatility. We already showed above that the XXXX ETN can lose significant value when the index oscillates +/- 3% due to the daily rebalancing of the exposure. In fact, this volatility decay effect increases with increasing volatility. For example, according to the issuer’s modeling, even if the underlying index delivers a positive return, the ETN can end up losing money if realized volatility is sufficiently high (with 20% volatility, the ETN is expected to lose 4.4% even if the underlying index returns 5%) (Figure 8).
Markets Extremely Overbought In The Short-Term
In the short-term, risk assets have gone virtually straight up since the beginning of November as investors anticipate the Federal Reserve easing monetary policy in 2024 and the mega-cap ‘Magnificent 7’ stocks continue to power markets higher.
On technical measures like RSI, the S&P 500 Index has been very overbought since December with negative divergence and prone to steep 1-day drawdowns like that experienced on December 20th (Figure 9).
With investor sentiment in ‘extreme greed’ territory, investors should be wary of pullbacks that can be magnified by XXXX’s leverage into steep drawdowns (Figure 10).
In summary, the XXXX ETN provides 4x exposure to the daily returns of the S&P 500 Total Return Index. Due to the extreme leverage employed by the XXXX ETN, I believe it should only be used for short-term swing trading by aggressive traders.
Although the XXXX ETN has performed very well since inception, investors are cautioned against projecting these returns into the future, as equity markets have essentially gone up in a straight line in the past few months. In more volatile markets, the XXXX ETN is expected to suffer from ‘volatility decay’ that can reduce performance. Furthermore, drawdowns can also be exceptionally painful with the XXXX ETN due to compounding and 4x leverage. A string of bad days (3% declines for 5 days) can cut the value of the ETN in half.
Currently, the S&P 500 Index is extremely overbought and investor sentiment is in ‘Extreme Greed’ territory, so I do not believe it is a good time to start a position in the XXXX ETN. I rate the fund as a hold for now.