If you can’t beat the market; LEVER IT. Seriously.
There’s no shortage of data out there indicating that very active management or factor investing fail to actively beat the market. Like this report by IFA that found 88.4% of actively managed funds did not outperform the market over a 15 year period.
So if your chances of out performance are low, why not just get more of the winner? Behold leverage.
While leverage is often shunned among the retail investor world, I believe it provides an excellent mechanism to provide systematic, enhanced returns (non-risk adjusted of course). And today there is more access to leveraged financial instruments than ever before and growing. One of which is leveraged ETFs.
I’m going to cover the leveraged ETF strategies I love. But I suggest reading some of the prerequisite information first.
What Is A Leveraged ETF?
Leveraged ETF’s use derivatives (commonly futures) to get more exposure for your invested dollar to particular financial instrument, index or market. The name of the ETF typically denotes the amount of exposure they get; 2x or 3x. 3x is the the highest… 4x etfs have been denied by the security and exchange commission.
Keep in mind this exposure works both for and against you. For example if you’re invested in a 3x S&P 500 etf such as UPRO or SPXL, and the S&P 500 goes up 2%, you have a 6% gain. If it went down’ by 2% you’re going to down by 6%
How Do Leveraged ETF’s Work?
Leveraged ETF's don't use loans to get the leverage, instead they use future contracts (and in some cases credit swaps) which can get leverage without interest.
With any kind of leverage there is risk of collapse during a prolonged drawdown. For example if a 3x leverage product saw a 30% decline in the underlying market over a month and had a 90% decline in its value, it would probably trigger a margin call. To avoid the risk of a significant drawdown causing a collapse they reset their futures holdings daily.
Leveraged ETF Decay
If the S&P 500 is up 10% over a few months you might be surprised to find that the return of the 3x levered fund is not up 30%. It’ll close, not quite 30%.
This is because levered ETF’s only track on a daily basis. They reset their leverage daily.
This results in a difference from tracking the underlying holding over a period of time. During a period of consistent daily highs with relatively low volatility, the etfs could actually go up more than their intended leverage target. But because the market isn’t reaching new highs daily (usually), Leveraged ETFs will typically under perform their intended leverage rate by a little bit.
Just as in the example of bull market with a levered ETF delivering more than the leverage rate, during a bear market the ETF can actually decline by more than the leverage rate.
Personally, I don’t see the decay as a huge problem. It is something to be aware of, but i just consider it ‘the cost of borrowing’. Leverage ETF’s don’t have to pay interest.
To get an idea of how much of a problem decay causes let’s look at a leveraged etf performance in a shitty market… emerging markets… which haven’t exactly been in a bull market. Its had a decade of volatility basically going sideways.
Source: Morningstar.com
Here we have the emerging markets index represented by Vanguards mutual fund VEIEX and the 3x Emerging markets fund EDC showing the cumulative growth of $10,000. While the index is up 59.13% the 3x fund is not up 177.39%, rather it down down 32.09%.
Despite this negative example, I don’t see the decay as a huge problem. It is something to be aware of. Holding a portfolio of low correlation of assets diversifies this risk.
The Optimal Asset Allocation To Lever
As we see from the emerging markets example above, diversification among lowly correlated asset classes is crucial if you are going to buy and hold leveraged products. When one goes down the other is up, or at least not down as much. Also sideways or down markets are killer with the decay. Bonds provide the consistent, steady, upstream and diversification needed.
In my research, an allocation of 60/40 - 40/60 consistently provides the highest risk adjusted return as measured by the Sharpe ratio.
My Golden Rule For Leveraged ETF Investing
Before we go to the strategies, I gotta share this.
>> Never go ‘all in’ to a strategy. I always take a dollar cost average approach.
Investing chunks over time diminishes the anchoring effect and makes the volatility a little easier to swallow.
All One With NTSX (1.5x Leverage)
The WisdomTree U.S. Efficient Core ETF (90/60) brings 150% returns from stocks and bonds all into a single fund. It’s a really a pretty cool product.
This is a single fund basically gets you 1.5 leverage on a 60/40 portfolio of the S&P 500 and intermediate term bonds.
There’s 2 things of particular interest with this fund.
How it gets leverage. Rather than levering the stock portion of the fund, it actually hold 90% stocks and then levers the remain 10% equity balance of bonds 6x. This keeps volatility decay to a minimum
Here’s a backtest of how this strategy performs compared to the S&P 500 going back to 1992.
With a 12.27% cagr and max monthly drawdown of 39.26%, the sharpe ratio of the NTSX strategy is 33.33% higher than the S&P 500.
It’s worth noting that the expense ratio of NTSX is only 0.2%. That’s damn near on par with low cost index funds.
Leveraged All Weather Portfolio (2x)
Coming Soon
Hedgefundie SPXL TMF Strategy (3x)
Coming Soon
Global 60/40 (3x or 2x)
With the relative value of international stocks (currently at a CAPE ration about 1/2 that of the US), I like having some exposure to them. Unfortunately there is no 3x international developed ETF. There is however a 3x emerging markets which may be better as it has less correlation to US equities developed equity markets.
Here we take the indexes in the following weights:
- 50% S&P 500
- 10% Emerging Markets
- 40% Long Term Treasuries
and lever it 3x, rebalance yearly.
In this backtest going back to Jan 1995 it has a cage of 27.01% and Sharpe ratio at 0.95%
This could portfolio could be constructed with the ETF's UPRO, EDC, TMF.