Long Term Use Of A Leveraged ETF

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Park
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Long Term Use Of A Leveraged ETF

Post by Park » Tue Jan 23, 2018 11:00 am

Periodic investing, also called dollar cost averaging, is a well known stock buying strategy. An example would be buying equal dollar amounts of a security every month. With such a strategy, you can take advantage of volatility. You buy more when the security is down in price and less when it is higher in price. It's a simple, but effective strategy.

https://www.sec.gov/comments/s7-24-15/s72415-35.pdf

The link above provides an example using a leveraged ETF. Between mid 2007 and early 2013, the S&P500 had 0% return. If you saved $1000 each month and got no interest on it, you would have had $69,000 between July 2007 and March 2013. In the middle of every month in that period, assume you put $1000 in SPY. At the end, you would have had $89,896 and about a 30% return.

Now assume you put $1000 in the middle of each month in SSO (2X leveraged ETF). At the end, you would have had $113,887 and a 65% return.

A major downside to leveraged ETFs is their increased volatility, which results in volatility drag. But a dollar cost averaging strategy, you take advantage of the volatility.

Another point to consider is costs. A common expense ratio is 1%, which is much higher than unleveraged index ETFs. But that doesn't include the cost of leverage, such as the embedded interest cost in derivatives and the transactional costs of trading such derivatives. However, I suspect that the cost of leverage will be at the institutional rate, which may be considerably less than what an individual investor would pay. I haven't seen any data on that though.

Another cost is tax. Tax cost ratio is a metric used by morningstar to assess tax costs. The following is an explanation:

"The Morningstar Tax Cost Ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions...if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)"

For the last 10 years, the following are the tax cost ratios of SSO (2X leveraged S&P500 ETF), SPY (S&P500 ETF) and IVV (S&P500 ETF): 0.23, 0.65 and 0.45.

Another tax metric that morningstar uses is tax-adjusted return:

"The tax-adjusted return shows a fund's annualized aftertax total return for the five- and 10-year periods, excluding any capital-gains effects that would result from selling the fund at the end of the period. To determine this figure, all income and short-term capital gains distributions are taxed at the maximum federal rate at the time of distribution. Long-term capital gains are taxed at a 15% rate. The after tax portion is then reinvested in the fund. State and local taxes are ignored"

For the last 10 years, the following are the pretax returns/tax adjusted returns of SSO, SPY and IVV: 10.87%/10.61%, 8.40%/7.69% and 8.45%/7.96%.

Morningstar provides information for the last 5 years on distributions of SSO. It's all in the form of income. For the last 5 years (2013-2017), yearly income has varied from $0.1325 per share to $0.4219 per share. In that time period, SSO varied in price from $30.18 to $122.86.

I thought that leveraged ETFs were tax inefficient, but I'm not so sure on that anymore.

I'd like to emphasize that I' would recommend against leveraging the US stock market at present valuations.

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Re: Long Term Use Of A Leveraged ETF

Post by Tyler Aspect » Tue Jan 23, 2018 11:26 am

A leveraged ETF has a lot of hidden risks. The borrowing cost is a constant downward pull on the performance. When the market drops, the investors of a leveraged ETF would experience the triple whammy: borrowing cost, market downturn, and leveraging of losses.
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Re: Long Term Use Of A Leveraged ETF

Post by Park » Tue Jan 23, 2018 2:25 pm

http://www.aaii.com/journal/article/lev ... nknown#box

The above link is about long term use of leveraged ETFs. A standard portfolio recommendation is 60% stocks and 40% bonds. This article discusses substitutes using 30% 2X ETF/70% bonds, 20% 3X ETF/ 80% bonds and 15% 4X ETF/85% bonds with monthly rebalancing from 1997-2016. More data is also given. The results you get with leveraged ETFs compare favorably to the traditional 60%/40% portfolio. A major advantage is that in a worst case scenario for stocks, you've limited your stock exposure, but still have the same exposure to the upside. Leveraged ETFs to manage risk?

https://poseidon01.ssrn.com/delivery.ph ... 98&EXT=pdf

The next link mixes leveraged ETFs with trend following. Volatility hurts leverage, and trend following is used to decrease exposure to leverage.

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Post by acanthurus » Tue Jan 23, 2018 2:36 pm

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Park
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Re: Long Term Use Of A Leveraged ETF

Post by Park » Tue Jan 23, 2018 3:04 pm

acanthurus wrote:
Tue Jan 23, 2018 2:36 pm
Park wrote:
Tue Jan 23, 2018 2:25 pm
http://www.aaii.com/journal/article/lev ... nknown#box

The above link is about long term use of leveraged ETFs. A standard portfolio recommendation is 60% stocks and 40% bonds. This article discusses substitutes using 30% 2X ETF/70% bonds, 20% 3X ETF/ 80% bonds and 15% 4X ETF/85% bonds with monthly rebalancing from 1997-2016. More data is also given. The results you get with leveraged ETFs compare favorably to the traditional 60%/40% portfolio. A major advantage is that in a worst case scenario for stocks, you've limited your stock exposure, but still have the same exposure to the upside. Leveraged ETFs to manage risk?

https://poseidon01.ssrn.com/delivery.ph ... 98&EXT=pdf

The next link mixes leveraged ETFs with trend following. Volatility hurts leverage, and trend following is used to decrease exposure to leverage.
I've looked into this and, in tax advantaged accounts, I think in the money LEAPS are a better choice. You ditch the volatility drag, the borrowing costs are usually lower, and the downside protection is explicit in the form of the strike price. If you roll well before expiration I don't think the theta decay would be too bad either, and you could lever up on the bond side in a similar fashion if so desired.

This forum thinks leverage is the devil though, so I probably wouldn't expect substantive discussion here. I think the one point that they get right is that the cost of the leverage is frequently not worth it. That's the one big hurdle IMO.
About using in the money LEAPS or leveraged ETFs (e.g. 30% 2X ETF/ 70% bonds) instead of the traditional 60%/40% portfolio, in the money LEAPS have some advantages. As you mention, there's no volatility drag. About borrowing costs being lower with LEAPS, that may be true. When I looked at deep in the money calls on SPY however, the effective interest rate wasn't that low. That must be balanced against the expense ratio of leveraged ETFs (usually around 1%), the interest cost embedded in the derivatives (probably comparable to the best rate IB offers (benchmark (LIBOR) + 0.3%), very likely much lower than a retail investor would get) and the daily transactional costs. But with leveraged ETFs, there's no expiration date and you don't have to worry about rolling them. With in the money LEAPS, there is the risk of your option expiring out of the money.

Edited to include the following: if you're having trouble accessing the AAII link, below is another link for the article:

http://www.theboxisthereforareason.com/ ... nknown.pdf

About the second link mixing leveraged ETFs with trend following, the authors assumed a 1% cost to using leveraged ETFs. However, they don't account for the interest and transaction costs of leveraged ETFs. Also, their model assumes about 5 transactions per year. However, transaction costs aren't included in their model.
Last edited by Park on Tue Jan 23, 2018 3:52 pm, edited 1 time in total.

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1nv35t
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Re: Long Term Use Of A Leveraged ETF

Post by 1nv35t » Tue Jan 23, 2018 4:28 pm

Park wrote:
Tue Jan 23, 2018 11:00 am
A major downside to leveraged ETFs is their increased volatility, which results in volatility drag. But a dollar cost averaging strategy, you take advantage of the volatility.
No. Their whole purpose is to provide twice (for 2x, three times for 3x) the daily volatility. An objective not a downside.

You can approximate yearly 2x gains using 2 x stock total return minus STT yield. For 3x you need to adjust to 6 monthly figures for those due to the higher volatility. In other words half in 2x, half in bonds will approximate 100% 1x (see here for a example that goes back to pre-2008 crisis)

Zvi Bodie extends that concept further, 90% in safe, 10% in effectively 10x leveraged stock (using LEAPS). But for reasonable tracking that requires even more regular rebalancing, perhaps monthly or more often. The "illusion" is that just 10% in risky will limit downside risk, which it does ... between rebalancing. Rebalancing repeatedly/often into a sustained down run however will tend to see losses compound to comparable levels as having held 1x all stock.

Reasons to perhaps use LETF's as buy and hold are more to do with tax efficiencies. If for instance dividends are highly taxed, bond interest is tax exempt then the low dividends that LETF's pay can make them more appealing than holding 1x. Be aware however that funds might be paying LIBOR or suchlike rates to borrow in order to provide leverage and at times, typically stressful times, they can deviate significantly from retail bond yields. LETF's are generally better in periods of low/stable interest rates, more risky during periods of high inflation/interest rates (especially if the bond interest you earn also sees taxes being raised).

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Re: Long Term Use Of A Leveraged ETF

Post by doon » Tue Jan 23, 2018 4:32 pm

Park wrote:
Tue Jan 23, 2018 11:00 am
Periodic investing, also called dollar cost averaging, is a well known stock buying strategy. An example would be buying equal dollar amounts of a security every month. With such a strategy, you can take advantage of volatility. You buy more when the security is down in price and less when it is higher in price. It's a simple, but effective strategy.

https://www.sec.gov/comments/s7-24-15/s72415-35.pdf

The link above provides an example using a leveraged ETF. Between mid 2007 and early 2013, the S&P500 had 0% return. If you saved $1000 each month and got no interest on it, you would have had $69,000 between July 2007 and March 2013. In the middle of every month in that period, assume you put $1000 in SPY. At the end, you would have had $89,896 and about a 30% return.

Now assume you put $1000 in the middle of each month in SSO (2X leveraged ETF). At the end, you would have had $113,887 and a 65% return.

A major downside to leveraged ETFs is their increased volatility, which results in volatility drag. But a dollar cost averaging strategy, you take advantage of the volatility.

Another point to consider is costs. A common expense ratio is 1%, which is much higher than unleveraged index ETFs. But that doesn't include the cost of leverage, such as the embedded interest cost in derivatives and the transactional costs of trading such derivatives. However, I suspect that the cost of leverage will be at the institutional rate, which may be considerably less than what an individual investor would pay. I haven't seen any data on that though.

Another cost is tax. Tax cost ratio is a metric used by morningstar to assess tax costs. The following is an explanation:

"The Morningstar Tax Cost Ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions...if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)"

For the last 10 years, the following are the tax cost ratios of SSO (2X leveraged S&P500 ETF), SPY (S&P500 ETF) and IVV (S&P500 ETF): 0.23, 0.65 and 0.45.

Another tax metric that morningstar uses is tax-adjusted return:

"The tax-adjusted return shows a fund's annualized aftertax total return for the five- and 10-year periods, excluding any capital-gains effects that would result from selling the fund at the end of the period. To determine this figure, all income and short-term capital gains distributions are taxed at the maximum federal rate at the time of distribution. Long-term capital gains are taxed at a 15% rate. The after tax portion is then reinvested in the fund. State and local taxes are ignored"

For the last 10 years, the following are the pretax returns/tax adjusted returns of SSO, SPY and IVV: 10.87%/10.61%, 8.40%/7.69% and 8.45%/7.96%.

Morningstar provides information for the last 5 years on distributions of SSO. It's all in the form of income. For the last 5 years (2013-2017), yearly income has varied from $0.1325 per share to $0.4219 per share. In that time period, SSO varied in price from $30.18 to $122.86.

I thought that leveraged ETFs were tax inefficient, but I'm not so sure on that anymore.

I'd like to emphasize that I' would recommend against leveraging the US stock market at present valuations.
OP - This may be a perfectly valid strategy. However for an average investor when we talk about buy & hold, its the hold part that is very difficult when say the markets are down 30% and the job market is shaky and your house price has gone down by 20%.

My point is with a leveraged ETF the psychological affect of downturn is much more pronounced and hence may prevent the investor from holding that ETF through the bear territory to reap the rewards later.
"Goal - Win the game before the need to retire"

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Tue Jan 23, 2018 4:43 pm

http://jii.iijournals.com/content/1/4/66

The above link tested whether using leverage selectively, depending on market volatility, could improve results.

The author outlines a strategy where the VIX is used to predict volatility. The VIX average from January 1990 to December 2009 was 20.2%. He mentions that the annualized daily volatility is a bit less than that, and that this overestimate decreased from 5% to 2% in 2003. In this strategy, the investor switches from index funds to constant leveraged funds when the VIX is less than 20, and vice versa when it is greater than 20. He compares this switching strategy to a buy and hold strategy of constant leveraged funds. He shows that from 1990 to 2009, results are similar, but the Sharpe ratio is higher for the switching strategy. From 1990 to 1999, the buy and hold strategy outperforms. But from 2000 to 2009, the buy and hold strategy results in losses, whereas the switching strategy results in gains. As mentioned previously, the high returns of 1990-1999 probably overcame the volatility drag.

The following numbers, from the link above, use the CRSP value weighted index from January 1926 to December 2009. They ignore costs and taxes. The annualized rate of return of the index was 9.66%. If the index was levered 2X and the leverage was rebalanced daily, the annualized return was 16.71%. For 3X leverage, the return was 20.46%

http://ibimapublishing.com/articles/JFSR/2013/715425/

"Given historical market returns and standard deviations,
equation (6) proves continuous decay is to be expected.
Inputting an annualized mean and standard deviation of 10% and
20% respectively, a 2x fund can expect to be down 3 percentage
points in a year relative to two times the underlying index return.
A 3x fund can expect to be down 9 percentage points within a
year. This is the basis for most studies concluding that investors
should not hold these funds for any extended period of time."

I doubt that a leveraged ETF can borrow at less than the federal funds rate. The link below states that the historical average of that rate is 4.89%.

https://ycharts.com/indicators/effectiv ... ate_annual

Assume 1% expense ratio for a leveraged ETF. Add 4.89% to that. Ignore daily transactional costs of a leveraged ETF. Add 3% for a 2X fund and 9% for a 3X fund. For a 2X fund, that means a headwind of 8.89% and one of 14.89% for 3X fund.

As mentioned previously, the annualized return of the CRSP value weighted index from Jan 26 to Dec 09 was 9.66%. Double that return and then subtract 8.89% to get 10.43% return. Triple the return of 9.66% and then subtract 14.89% to get 14.09% return.

So a 3X ETF might work. But if the market goes down 33.3% in one day, you're wiped out. The S&P500 has gone down about 20.5% in one day.

About using leveraged ETFs and dollar cost averaging, the following comment has been made by another. With time, your monthly contribution may become small relative to the amount of money invested. So the extra return you're getting from the volatility disappears, and you're left with the decreased return associated with volatility drag. With a long enough time period, it may not be a good strategy.

Edited to include the following: I estimate 4.89% to borrow money. However, for a 2X ETF where half the money is borrowed, it will cost the fund 2.445% each year to borrow. For a 3X ETF, it will cost 3.26% to borrow.

When you run the numbers again, that means a 2X ETF would have headwind of 6.445% and a 3X ETF would have a headwind of 13.26%. So for an index return of 9.66%, the 2X ETF might have returned about 12.875% and the 3X ETF about 16.105%.
Last edited by Park on Tue Jan 23, 2018 5:19 pm, edited 2 times in total.

Theoretical
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Re: Long Term Use Of A Leveraged ETF

Post by Theoretical » Tue Jan 23, 2018 4:50 pm

I've looked at Direxion's monthly leveraged index funds and the returns historically are about equivalent to 2x less the ER for at least the 7-10 year treasury Bond and s&p 500 indexes. They use swaps and are pretty transparent about what they're doing and how it functions.

The biggest advantage of the leveraged bond fund is a stock-like tax cost ratio. That means it could have some limited use in ultra high tax brackets or trusts (automatically max if they retain much of any income).

And they do function like volatile versions of the indexes.

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Tue Jan 23, 2018 5:36 pm

Theoretical wrote:
Tue Jan 23, 2018 4:50 pm
I've looked at Direxion's monthly leveraged index funds and the returns historically are about equivalent to 2x less the ER for at least the 7-10 year treasury Bond and s&p 500 indexes. They use swaps and are pretty transparent about what they're doing and how it functions.

The biggest advantage of the leveraged bond fund is a stock-like tax cost ratio. That means it could have some limited use in ultra high tax brackets or trusts (automatically max if they retain much of any income).

And they do function like volatile versions of the indexes.
I could see the use of a leveraged bond fund, if high tax on interest income is an issue. Another possiblity might be bond futures or options (sale of deep in the money calls).

As mentioned in two previous posts by others, a major advantage of leveraged ETFs may be stock/bond exposure in a more tax efficient manner.

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Re: Long Term Use Of A Leveraged ETF

Post by Phineas J. Whoopee » Wed Jan 24, 2018 6:18 pm

I don't want to get into another argument on the same topic with you Park, and obviously you can buy whatever you like, but lest anybody else misunderstand I will again post this link:

Bogleheads wiki: Inverse and leveraged ETFs

PJW

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Re: Long Term Use Of A Leveraged ETF

Post by not4me » Thu Jan 25, 2018 11:29 am

Far too much for me to read, but is there a specific leveraged ETF under discussion OR just a theoretical discussion? I ask (& this may be part of what Phineas J Whoopee was addressing) because at least some of the actual products on the market specifically say they are not intended for "long term" use. Its been a while, but I had looked into using myself for a fairly specific need. At that point, they seemed to go out of their way to say that wasn't their design. There may be some new (or ones I just didn't see) products, but if so I'd like to see them identified

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Re: Long Term Use Of A Leveraged ETF

Post by lack_ey » Thu Jan 25, 2018 12:01 pm

not4me wrote:
Thu Jan 25, 2018 11:29 am
Far too much for me to read, but is there a specific leveraged ETF under discussion OR just a theoretical discussion? I ask (& this may be part of what Phineas J Whoopee was addressing) because at least some of the actual products on the market specifically say they are not intended for "long term" use. Its been a while, but I had looked into using myself for a fairly specific need. At that point, they seemed to go out of their way to say that wasn't their design. There may be some new (or ones I just didn't see) products, but if so I'd like to see them identified
If you were asking if new products don't behave in the same way with respect to leverage resetting daily, no, it's the same. Most all of the daily leveraged products claim to not be for long-term use. That doesn't mean you can't use them that way, though. Who really cares what the intent is?

You just should understand the increased volatility drain and the effective cost of leverage. That said, there are other ways of accessing leverage that may be more suitable depending on aims, and also less costly.

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Re: Long Term Use Of A Leveraged ETF

Post by not4me » Thu Jan 25, 2018 2:15 pm

lack_ey wrote:
Thu Jan 25, 2018 12:01 pm
not4me wrote:
Thu Jan 25, 2018 11:29 am
Far too much for me to read, but is there a specific leveraged ETF under discussion OR just a theoretical discussion? I ask (& this may be part of what Phineas J Whoopee was addressing) because at least some of the actual products on the market specifically say they are not intended for "long term" use. Its been a while, but I had looked into using myself for a fairly specific need. At that point, they seemed to go out of their way to say that wasn't their design. There may be some new (or ones I just didn't see) products, but if so I'd like to see them identified
If you were asking if new products don't behave in the same way with respect to leverage resetting daily, no, it's the same. Most all of the daily leveraged products claim to not be for long-term use. That doesn't mean you can't use them that way, though. Who really cares what the intent is?

You just should understand the increased volatility drain and the effective cost of leverage. That said, there are other ways of accessing leverage that may be more suitable depending on aims, and also less costly.
I think we're in sync, but you didn't really correctly guess my intent. So, you asked "who cares the intent".... I understand that someone may use a mouse trap for purposes other than trapping a mouse. Use it as you wish. Use it to try and catch a bear...I don't think it'll work & the maker never claimed it would. Better ways to catch a bear? yep. My question was along the lines of whether someone was claiming to have produced a better mouse trap....one that could catch a bear. Sounds like no such claim... just rehash of same old, same old. Not 1st time I've seen discussions on the board about how this, that, the other works in an environment separate & apart from real world....I just wasn't precluding the (unspoken) possibility that a new, innovative approach was now out there

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Thu Jan 25, 2018 8:52 pm

I'm not saying that I"m in favor of long term use of leveraged ETFs, but I would like to look at the data, before drawing conclusions.

http://quotes.morningstar.com/chart/etf ... ctcode=COM

SSO (2X S&P500) goes back to June 20/06. Since then, it is up 251%. VFINX (Vanguard S&P500) is up 126.7%. That's only 11.5 years, but nevertheless, it contains the worst stock drawdown in nominal terms since the Depression.

No form of leverage is perfect. But there is no margin call risk, leveraged ETFs can be low maintenance, they're reasonably tax efficient, and may be one of a limited choice of leverage accessible in a tax advantaged account.

About the cost of leverage, its' definitely higher than that of futures or tax deductible margin at IB. But compared to the leverage costs of options (deep in the money calls on SPY), it's not that bad. And it's likely cheaper than the margin rates of my brokerages.

Leverage drag is an issue. That's why I'd prefer using products that lever broad market cap indexes. The broader the index, the lower the volatility tends to be. Similarly, if leverage gets too high, the volatility drag becomes stronger, and the increased leverage becomes counterproductive. That's why I'd wouldn't put money in 3X ETFs. I believe that volatility drag is a major reason why the inverse products don't work well long term. But I could only see using the inverse ETFs as a short term way to hedge risk.

https://blog.thinknewfound.com/2018/01/ ... -long-run/

Above is a link about long term use of leveraged ETFs.

Personally, I'd stick with IB margin in a taxable account. In a tax advantaged account, leveraged ETFs make more sense, although I'm still not convinced
enough to use them. I do find the combination of trend following and leveraged ETFs to be intriguing.

I've also heard the case made for going 50% 3X ETF and 50% cash. I've never seen an analysis of that though.

Finally, I once again would not recommend levering the US stock market at present.

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Re: Long Term Use Of A Leveraged ETF

Post by foo.c » Thu Jan 25, 2018 9:07 pm

I used portfolio visualizer to backtest 67% cash and 33% SPXL and it had almost exactly the same result as 100% S&P500, but the most you could have lost was 33% vs. 100% in the all S&P500 (although that would be almost impossible and sign of a bigger problem).

I put 10k into a fun account of all leveraged ETFs and I'm up 20% so far this month. I fully expect this to have a large, rapid decline at some point this year, but I am following an algorithm which should limit the risk. If I was really brave I would leverage these leveraged ETFs.

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Re: Long Term Use Of A Leveraged ETF

Post by pastel » Thu Jan 25, 2018 9:20 pm

I'm staunchly against leveraged ETFs. Yes, they are great when markets are up and volatility is down. But just as these gains can multiply, so can the losses.

A quick look at a leveraged ETF prospectus shows that even if overall markets are up, your investment can still decline if there is high volatility.

The recent spike in the markets definitely makes these investments look attractive, but I'm sticking with the Boglehead philosophy - slow and steady.

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Re: Long Term Use Of A Leveraged ETF

Post by 1nv35t » Thu Jan 25, 2018 9:26 pm

Leveraged ETF's can be useful to rebalance without having to sell bonds and your brokers margin rates are prohibitive or simply unavailable. If you're locked into a 1 year bond and a need to rebalance occurs to increase stock exposure from $90,000 to $100,000 that you hold in SPY, and you have $100,000 locked into one year bonds that don't mature for another 3 months, then selling $10,000 of SPY to buy $10,000 of 2x S&P500 will have realigned your stock exposure as desired (as though $10,000 of bonds had been paired with that $10,000 of 2x to compare to $20,000 of 1x). Then when the bonds mature you have the option to reset back to all 1x again without having incurred any bond early exit penalty; Or simply let it ride and if the next rebalance is to reduce stock exposure the reduce out of the 2x first.

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Thu Jan 25, 2018 10:09 pm

I used portfolio visualize to compare SSO (2X S&P500) with Vanguard S&P500 fund. Since 2006, the maximum drawdown of the Vanguard fund was about 51%. The maximum drawdown of SSO was predictably worse at 81.35%, but that's still not double of 51%.

Once again, I'm not advocating long term use of ETFs, and I don't feel comfortable using them myself. However, I don't want to dismiss them out of hand.

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Re: Long Term Use Of A Leveraged ETF

Post by 1nv35t » Thu Jan 25, 2018 10:17 pm

See this link/version of portfoliovisualizer and check out the CAGR, maxDD etc. figures.

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Fri Jan 26, 2018 12:46 am

http://beta.morningstar.com/funds/xnas/ulpix/quote.html

ProFunds has had a mutual fund whose precost goal is to provide double the return of the S&P500 each day. The start date was Nov 26/1997, so it has a bit more than a 20 year history, which includes two bad bear markets. Assume $10K at the start date. As of Jan 25/18, the mutual fund has a value of $40,776.24. Total return of S&P500 would have resulted in $43,582.28. On a precost basis, one would expect the fund to have a worth of about $87K.

The 1.42-1.70% expense ratio, along with the undisclosed interest and daily transaction costs, explains part of the underperformance. However, the mutual fund was outperforming until 2001, but has underperformed since then. When you look at the chart, you notice the devastating effect of the two bear markets since 1997. After each bear market, the fund is playing catchup. In 2007, it was getting close to the return of the S&P500, but then the second bear market came. There's been a repeat of the catchup lately.

What have I learned from this? Costs are important :oops:. Volatility hurts leverage, and the higher your leverage ratio, the more it hurts. If you are going to use leverage, keep your leverage modest. Diversification and leverage work well together; diversification should most likely decrease your volatility. Entry points matter. To start leverage when valuations are high, such as now, can be a painful experience. If you lever when valuations are low, you increase your probability of success. To take an extreme example, if you invested $3,561 in this fund or $10,177 in the S&P500 in March 31/09, you would have close to the same amount of money at present with either option. The last few sentences might be taken as endorsement of valuation based market timing. But if you're levering broad market indexes, you should have a time horizon of at least one market cycle, which effectively means a minimum of at least 5 years. And the only predictors I've seen of stock market performance over time periods greater than 5 years are valuations. I realize though that valuations are noisy predictors, except possibly at extremes. The present market may be one of those exceptions.

The comments of the previous paragraph apply to leverage in general. However, I think there are better ways to obtain long term leverage than leveraged ETFs, with tax deductible margin at IB being one of them. About tax advantaged accounts, futures would work, if you can access them. I'm not convinced, that other forms of leverage including leveraged ETFs or options, are worth pursuing.

Possibly the most effective form of leverage is increasing your stock allocation. Stocks are inherently levered, and have the added attraction of being nonrecourse debt. A tilt to value stocks might also be useful, as companies whose stocks are classified as value, tend to be more indebted.

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Re: Long Term Use Of A Leveraged ETF

Post by 1nv35t » Fri Jan 26, 2018 5:35 am

Park wrote:
Fri Jan 26, 2018 12:46 am
http://beta.morningstar.com/funds/xnas/ulpix/quote.html

ProFunds has had a mutual fund whose precost goal is to provide double the return of the S&P500 each day. The start date was Nov 26/1997, so it has a bit more than a 20 year history, which includes two bad bear markets. Assume $10K at the start date. As of Jan 25/18, the mutual fund has a value of $40,776.24. Total return of S&P500 would have resulted in $43,582.28. On a precost basis, one would expect the fund to have a worth of about $87K.
Leveraged funds provide twice the daily volatility. They most certainly won't provide twice the mid to longer term gains/loss. Indeed they might tend more towards providing the same reward as the 1x.

You can approximate yearly 2x gains/losses using 2 times the SPY total return minus short term treasury yield. Half in 2x, half in STT will generally compare to 100% 1x.

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Re: Long Term Use Of A Leveraged ETF

Post by aristotelian » Fri Jan 26, 2018 7:33 am

I was thinking about this as well. Meb Faber has talked about using leveraged ETFs in a buy and hold strategy. I am curious, though, what would be the risk/return difference between allocating a portion of my portfolio to a 2X S&P fund versus reducing my bond allocation. Let's say I am 80/20. Is there any difference in risk/return between these two portfolios?

Portfolio 1:
80% Total US stock
20% Total US Bond

Portfolio 2:
10% 2X S&P
60% Total US stock
30% Total US Bond

Backtesting to 2008 with SSO, Portfolio visualizer says #2 outperforms very slightly by 0.25%, but I am not sure why. I guess you get a little more return on the bond side with the same return on the stock side?

In any case, it appears the main reason for 2X S&P would be for investors who are willing to go in excess of 100% stock, but otherwise one can achieve the same result simply by increasing stock and decreasing bond.

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rhe
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Re: Long Term Use Of A Leveraged ETF

Post by rhe » Fri Jan 26, 2018 8:54 am

I have an allocation somewhat similar to what is being discussed, but I don't use leveraged ETFs. I think the right way to take these sorts of positions is with treasury futures.

My portfolio is a basic 60/40 portfolio leveraged out 1.5 times, so you could call it 90/60. I hold the 90% stock in plain vanilla vanguard ETFs. The bond position I take using mainly treasury futures, plus a few plain vanilla vanguard ETFs. I use US, German, Canadian, and Australian futures. There is basically no currency risk because with the futures you are short as much of the currency as you are long.

The cost of holding the position is minimal, because the spread on the futures is very low, and the financing cost should be something close to the repo rate, because the bonds serve as collateral.

I see two advantages to using leverage on the bond side rather than the stock side. First, the financing cost is lower because with stocks financing would be at the unsecured rate rather than the secured rate. Second, bonds are so stable that you only have to touch the portfolio once every few months.

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Re: Long Term Use Of A Leveraged ETF

Post by rhe » Fri Jan 26, 2018 9:01 am

With regards to options, I agree that they are probably cheap in the same way that futures are, but I think there is a problem because your (effective?) leverage ratio changes as the market moves. A deep in the money option has a different response to market movements than one that's far out of the money. It seems like you would either need to give up on keeping a Kelly style constant leverage ratio, or you would have to constantly manage the portfolio...

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Fri Jan 26, 2018 10:05 am

aristotelian wrote:
Fri Jan 26, 2018 7:33 am
I am curious, though, what would be the risk/return difference between allocating a portion of my portfolio to a 2X S&P fund versus reducing my bond allocation. Let's say I am 80/20. Is there any difference in risk/return between these two portfolios?

Portfolio 1:
80% Total US stock
20% Total US Bond

Portfolio 2:
10% 2X S&P
60% Total US stock
30% Total US Bond

Backtesting to 2008 with SSO, Portfolio visualizer says #2 outperforms very slightly by 0.25%, but I am not sure why.
A simple reason might be diversification. In portfolio 1, bonds are 20 out of 100. In portfolio 2, bonds are 30 out of 110. Since bonds have less than a 1.0 correlation with stocks, portfolio 2 is more diversfied and will have a lower volatility; the lower volatility results in increased CAGR.

That's one reason why you hear of levering a stock/bond portfolio. I have two issues with that. To lever bonds, you need a low interest rate. Institutional investors can do that. But for individual investors, my impression is that bond futures are the only way to get a low enough interest rate that levering bonds makes sense. My second issue with levering a stock/bond portfolio is in a taxable account. If your interest costs are fully deductible against ordinary income and stocks are taxed more favorably than ordinary income, it is possible to lever stocks and have a negative pretax return and a positive posttax return. But if bond returns are taxed as ordinary income, that's not possible with levering bonds.

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Re: Long Term Use Of A Leveraged ETF

Post by nisiprius » Fri Jan 26, 2018 10:14 am

The providers of leveraged ETFs and mutual fund say themselves, in only slightly veiled language, that they are not intended for long-term use. Why shouldn't we heed that?

Here are Direxion's own words. The underlining is mine. Short term. Actively manage their investments. And while they don't quite say it in so many words, when they say "TRADING is different than investing" I think they are saying "And our tools are for TRADING."

Direxion Daily S&P 500 Bull 2X Shares
This leveraged ETF seeks a return that is 200% the return of its benchmark index for a single day. The fund should not be expected to provide two times the return of the benchmark’s cumulative return for periods greater than a day....

You know that TRADING is different than investing. But the opportunity to take advantage of short-term trends is only won, if you get the direction right.

Our leveraged ETFs are powerful tools built to help you:
  • Magnify your short-term perspective with daily 2X leverage
  • Stay agile – with liquidity to trade through rapidly changing markets
....
They are not suitable for all investors and should be utilized only by investors who understand leverage risk and who actively manage their investments.
P.S. Direxion is the company that tried to launch leveraged bitcoin ETFs the other day (and was shot down by the SEC), so you can assume they are not inclined to be timid about recommending leveraged ETFs.
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Park
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Re: Long Term Use Of A Leveraged ETF

Post by Park » Fri Jan 26, 2018 11:45 am

acanthurus wrote:
Fri Jan 26, 2018 10:29 am
nisiprius wrote:
Fri Jan 26, 2018 10:14 am
The providers of leveraged ETFs and mutual fund say themselves, in only slightly veiled language, that they are not intended for long-term use. Why shouldn't we heed that?
I always figured it was boilerplate to cover their bums if idiots stuck their entire life savings in a 3x equity etf and then later sued them.

I mean, my box of q-tips says not to stick them in my ear, but guess how those get used.
+1

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Re: Long Term Use Of A Leveraged ETF

Post by pastel » Fri Jan 26, 2018 1:22 pm

Let me jump in again and say that we shouldn't be looking just at total returns, but total risk adjusted returns. Yes, leveraged funds may provide greater returns in some portfolios, but they are likely increasing the overall risk of the portfolio. Higher risk should result in higher returns.

Also, many leveraged ETFs use options for their leverage, meaning they will not return regular dividends.

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Re: Long Term Use Of A Leveraged ETF

Post by Park » Fri Jan 26, 2018 1:43 pm

acanthurus wrote:
Fri Jan 26, 2018 8:21 am
Am I in crazy land for thinking options are a far cheaper alternative without the downsides of daily resetting leverage? Jan 2019 SPX call with a 1400 strike was last traded at ~1430 and that's your ~2x leverage right there. If that's too rich for a full contract (143k) then the SPY call should be roughly 1/10th that. In a tax advantaged account I don't see how any other form of leverage beats this. In taxable accounts I could see a case being made for margin or leveraged ETFs but only because of tax cost of rolling the options contracts.
My experience with options is slight, and is from a few years back. This is how I how determine the interest rate on a deep in the money call on SPY; please correct me if I'm wrong. I'm ignoring the bid/ask spread and commissions costs of directly buying SPY, instead of an option on SPY.

At the time I took the information, SPY was at $285.199/share. The $145 call option on SPY expiring Jan 18/19 had a bid/ask of $140.37/$140.86.

If you buy the $145 call, you have effectively borrowed $144.339 to get 100% exposure to SPY until Jan 18/19. If you want to continue having 100% exposure to SPY on Jan 18, you'll have to pay $145 on that date.

So you saved $0.661 by buying the option.

However, you've forgone the dividend. An internet search gives the dividend yield of SPY as 1.91%. So you lost $5.4435 in dividends.

You also will pay commissions buying and selling the option. TD Ameritrade charges $6.95+$0.75 per contract. One contract is 100 stocks. Assume you buy and sell one contract. So on a per share basis, commission cost you $0.154 per share.

$0.661 minus $5.4435 minus $0.154 is -$4.9365 per share.

So the effective interest rate is 1.73%. That is a low and very competitive rate of interest.

However, option pricing depends on volatility.

https://finance.yahoo.com/chart/%5EVIX# ... MX19XX0%3D

VIX is at 11.30. When I go back to around 1990, that is in the bottom 5% (bottom 1%?). So volatility is very low, which in part is driving the low effective interest rate.

The effective interest rate on options could go up a lot from the present rate.

Also, I've only examined SPY here, which has possibly the most liquid options of any stock. Options on other ETFs will very likely be higher.

Also, if S&P500 declines by more than 50% by Jan 18/19, you've lost everything on that option.

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