Know more about daily rebalancing
Leveraged and inverse products (L&I Products) are often regarded as “daily” products because these products aim to deliver a multiple of or a multiple of the opposite of the return of its underlying index on a daily basis. They have to rebalance their portfolio on a daily basis in order to achieve their investment objective.
How does rebalancing work?
Each L&I Product is subject to a leverage factor, which specifies the multiple of the daily index return that the L&I Product aims to achieve. For example, a 2x leveraged product aims to deliver a daily return equivalent to two times the underlying index return. A -1x inverse product aims to deliver the opposite of the daily return of the underlying index.
In Hong Kong, the leverage factor of leveraged products is capped at two times (2x) and the leverage factor of inverse products is capped at two times (-2x).
A L&I Product mainly invests in derivatives, typically swaps or futures to achieve its investment objective (i.e. to deliver the daily target return based on the leverage factor).
The index exposure and leverage factor of a L&I Product may change as the underlying index moves during the trading day. As such, the L&I Product has to rebalance its portfolio in order to restore the leverage factor back to its target level. This is done on a daily basis.
Example: Daily rebalancing of a 2x leveraged product in a down market
Assume that a 2x leveraged product’s net asset value (NAV) (i.e. index level) is $100 and its exposure to the underlying index is $200 (2x index exposure) at the beginning.
During Day 1, the underlying index drops by 1%. At the end of Day 1, the 2x leveraged product’s NAV drops to $98 and its exposure to the underlying index also drops to $198 ($200 x (100% -1%)). If daily rebalancing does not take place, the leverage factor will become 2.02x ($198/ $98) instead of 2x.
On the other hand, if the 2x leveraged product rebalances its portfolio by reducing its underlying index exposure by $2 to $196, the leverage factor will be restored to 2x ($196/$98).
Example: Daily rebalancing of a 2x leveraged product in an up market
Assume that a 2x leveraged product’s NAV (i.e. index level) is $100 and its exposure to the underlying index is $200 (2x index exposure) at the beginning.
During Day 1, the underlying index rises by 1%. At the end of Day 1, the 2x leveraged product’s NAV increases to $102 and its exposure to the underlying index also rises to $202 ($200 x (100% + 1%)). If daily rebalancing does not take place, the leverage factor will become 1.98x ($202/ $102) instead of 2x.
On the other hand, if the 2x leveraged product rebalances its portfolio by acquiring additional underlying index exposure of $2 to $204, the leverage factor will be restored to 2x ($204/$102).
Example: Daily rebalancing of a -1x inverse product in a down market
Assume that a -1x inverse product’s NAV (i.e. index level) is $100 and its short exposure to the underlying index is $100 (-1x index exposure) at the beginning.
During Day 1, the underlying index drops by 1%. At the end of Day 1, the -1x inverse product’s NAV increases to $101 while its short exposure to the underlying index drops to $99 ($100 x (100% -1%)). If daily rebalancing does not take place, the leverage factor will become -0.98x (-$99/ $101) instead of -1x.
On the other hand, if the -1x inverse product rebalances its portfolio by increasing its short exposure of underlying index by $2 to $101, the leverage factor will be restored to -1x (-$101/$101).
Example: Daily rebalancing of a -1x inverse product in an up market
Assume that a -1x inverse product’s NAV (i.e. index level) is $100 and its short exposure to the underlying index is $100 (-1x index exposure) at the beginning.
During Day 1, the underlying index rises by 1%. At the end of Day 1, the -1x inverse product’s NAV drops to $99 while its short exposure to the underlying index rises to $101 ($100 x (100% + 1%)). If daily rebalancing does not take place, the leverage factor will become -1.02x (-$101/ $99) instead of -1x.
On the other hand, if the -1x inverse product rebalances its portfolio by reducing its short exposure of underlying index by $2 to $99, the leverage factor will be restored to -1x (-$99/$99).
Example: Daily rebalancing of a -2x inverse product in a down market
Assume that a -2x inverse product’s NAV (i.e. index level) is $100 and its short exposure to the underlying index is $200 (-2x index exposure) at the beginning.
During Day 1, the underlying index drops by 1%. At the end of Day 1, the -2x inverse product’s NAV increases to $102 while its short exposure to the underlying index drops to $198 ($200 x (100% -1%)). If daily rebalancing does not take place, the leverage factor will become -1.94x (-$198/ $102) instead of -2x.
On the other hand, if the -2x inverse product rebalances its portfolio by increasing its short exposure of underlying index by $6 to $204, the leverage factor will be restored to -2x (-$204/$102).
Example: Daily rebalancing of a -2x inverse product in an up market
Assume that a -2x inverse product’s NAV (i.e. index level) is $100 and its short exposure to the underlying index is $200 (-2x index exposure) at the beginning.
During Day 1, the underlying index rises by 1%. At the end of Day 1, the -2x inverse product’s NAV drops to $98 while its short exposure to the underlying index rises to $202 ($200 x (100% + 1%)). If daily rebalancing does not take place, the leverage factor will become -2.06x (-$202/ $98) instead of -2x.
On the other hand, if the -2x inverse product rebalances its portfolio by reducing its short exposure of underlying index by $6 to $196, the leverage factor will be restored to -2x (-$196/$98).
What are the implications of rebalancing?
As a result of rebalancing, a L&I Product is only expected to track the multiple of or the multiple of the opposite return of the underlying index for the rebalancing interval, typically one day. It may not track the multiple of or the multiple of the opposite return of the underlying index when it is held for less than a full trading day or overnight.
8 May 2019
