- How Volatility Drift Affects FLI Products
The cryptocurrency market has experienced high levels of volatility recently.
This volatility was felt even more acutely by investors in Flexible Leverage Index (FLI) products. These products are appealing because they allow investors to gain exposure to leveraged returns on both Ethereum and Bitcoin, while greatly reducing the risk and complexity normally associated with leveraged trading. FLI investors can experience exceptional performance while the market is on an upward trajectory. However, these products are sensitive to volatility, and investors should take the time to understand how they perform in all market conditions. An awareness of how these products behave in response to volatility will help investors to make better decisions and limit their exposure to risk.
As leveraged index assets, the FLI products will experience a degree of “volatility drift”. Over time, the valuation of leveraged assets tends to deviate from the expected leveraged returns of the underlying asset.
In a positive market move with limited volatility, the leveraged asset can outperform a simple multiple of the underlying asset. In this situation, steady returns are “locked in” each day and compound over time.
In a more volatile market, however, leveraged assets may underperform expectations. Because the assets are leveraged, the effect of the losses are also multiplied by a factor of the leverage ratio. Over time these losses can reduce the positive impact of the leverage during a broadly positive market move. Crucially, the likelihood of experiencing a loss on any given day in the market increases over time, with multiple losses becoming more likely over longer time-frames. This means FLI becomes a riskier asset to hold over time. FLI investors should take note of this phenomenon and design an appropriate portfolio strategy to gain the full benefit of trading these products.
What are leveraged products?
Taking a step back, leverage is when you borrow against your capital to purchase additional holdings and increase the size of the investment you have in any kind of asset.
Using leverage comes with risks and rewards. Leveraged index products are a popular strategy in traditional finance, enabling investors to gain exposure to assets via leverage without having to take on all the risk and complexity. However, there are still risks associated with holding leveraged index products.
One important point to note is that over an extended period of time, leveraged assets can deviate from the expected multiple returns from the underlying assets due to the impact of both positive and negative price movements. This effect is known as volatility drift and it is a widely documented phenomenon in traditional finance (deep dive: Zhang 2010).
How do leveraged products work?
In traditional finance, a leveraged index such as the SPUU enables an investor to gain exposure to double leveraged returns on the SP500 stock index. A leveraged index product is designed by choosing an underlying asset (or basket of assets) and determining a target leverage ratio. Holdings in the underlying asset are used as collateral by the index fund for purchasing more of the underlying asset up to the target ratio level.
In the case of the SPUU and FLI products that ratio level is 2. Each day, based on price changes of the underlying asset, the leveraged index fund will buy or sell additional quantities of the underlying asset to rebalance towards the selected leverage ratio level.
From an investor’s perspective, each of these rebalances can be thought of as the index product locking in the return from that day — whether it is a gain or a loss. This continuous act of rebalancing can lead to the price of the index fund reflecting both the losses and the gains in the price of the underlying asset over time. Because leverage is being used, the impact of the losses are also multiplied by a factor of the leverage ratio. When compounded over time, this can lead to the returns of the leveraged product deviating from the expected returns of leveraging the underlying product. This phenomenon is called beta slippage or volatility drift.
The FLI product suite uses the same fundamental strategy as a traditional index fund, except the underlying assets are either Bitcoin or Ethereum. Similar to the leverage ratio of the SPUU, the FLI products target a leverage ratio of 2 except they use a flexible target that floats between 1.7–2.3 in the case of EHT2X-FLI and 1.8–2.2 in the case of BTC2X-FLI.
The effect of the flexible target is that FLI products are less reactive to volatility compared to the hard rebalance strategies used in traditional leveraged index funds. This flexibility reduces the effect of short-term price fluctuations on the price of FLI, but it does not completely mitigate the effect of volatility drift.
What is the effect of volatility drift?
The best way to understand the effect of volatility drift over time is to use an example.
In the table below, we can track the performance of an initial investment of $1,000 in a regular asset and an investment of the same value in a leveraged version of that asset that rebalances to a leverage ratio of 2 each day.
Over 8 days of simulated trading our underlying asset returns a loss or a gain of 50 dollars each day before returning to our initial investment price of $1,000. Similarly, our leveraged asset tracks the same price movement each day, but because leverage is used the returns are multiplied by 2 and any gains or losses are locked in that day when the leveraged asset rebalances.
At the end of our trading period, our investment in the underlying asset has returned to its initial value of $1,000 but the investment in the leveraged asset is now only worth $980 — a loss of about 2%.
This is volatility drift in action. In this example, the magnified impact of negative trading days in the market outperformed the impact of positive trading days. The opposite effect can happen, and in sustained positive market moves, returns can accrue and lead to the leveraged asset outperforming the expected returns of leveraging the underlying asset. Importantly for investors in cryptocurrencies, the risk of a leveraged asset underperforming is directly proportional to the volatility of the underlying asset and the amount of time in the market.
How volatility drift could affect FLI products
As a new and emerging technology sector and asset class, blockchain and cryptocurrencies experience much higher levels of volatility than most traditional assets. This is both a positive and a negative aspect of trading in cryptocurrencies; investors can expect years with returns that are many multiples of the value of their initial investment, but should also expect very large price fluctuations along the way.
Gauging the relative impact of these factors on your expected ETH2X-FLI return is crucial when deciding on a trading strategy. Using the last 90 days of trading history for Ethereum (HV90), it is possible to model the impact of volatility drift on a holding of ETH2X-FLI using this formula from a blog post by Jay Wolberg. It is important to note that ETH volatility has been extremely high for much of this period, so the effect would not be as pronounced in a less volatile market. This model also assumes a hard rebalance formula so some of the higher figures from the 30 day period below would probably exceed the actual performance of ETH2X-FLI as the leverage ratio would track a figure closer to 1.7 during such steep upward price action. Similarly, it may track closer to 2.3 during a steep negative correction.
Using recent market conditions as our baseline for volatility, it is apparent that the positive impact of the leverage ratio can be diminished over longer time-frames in volatile markets. In the case where you are expecting a 50% gain in ETH over 30 days, you can expect a return close to twice that from ETH2X-FLI during the same period. However, over longer periods and with high volatility, you can expect to see that return greatly diminished. After about 90 days, if you are expecting about a 50% return, there is no advantage to holding FLI over ETH during a volatile period.
This picture changes completely with higher expected returns. If you are expecting to see the price of ETH double or triple over the next 3 months, then there is an advantage to holding ETH2X-FLI despite high volatility. In a situation where ETH increases by 200% in a short period of time, investors can expect to experience positive volatility drift as daily gains are locked in and the price of FLI reflects this compounding of leveraged returns. Over time, the probability of experiencing multiple negative daily returns increases and the expected return should be lower.
FLI products provide a great opportunity for investors to increase their exposure to Bitcoin and Ethereum when they expect to see strong returns in the near future. In this situation, FLI can experience returns that exceed the target leverage ratio as positive daily returns are compounded. However, cryptocurrency markets are historically volatile and FLI products will be sensitive to that volatility. Over time, the probability of experiencing high volatility in the underlying asset increases and investors should take action to limit their risk accordingly. A successful strategy should involve a consideration of both the expected return and the expected time frame to realize it.
Holding a FLI product over an extended period of time may yield great returns, but it is a very high risk strategy. Using a FLI product to target short term price movements is a more effective way to realize the upside on a positive market trend, while managing risk and protecting your investment.
You can use this calculator to estimate how an investment in ETH2X-FLI might perform over the next few months in both positive and negative market conditions, based on recent levels of volatility.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.
- Date of publication:
- Fri, 06/11/2021 - 11:34
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