The Risk of Avoiding Leveraged ETFs

Plenty of people will never understand the best use cases for daily leveraged ETFs. That’s perfectly fine. Every investment is personal choice as well as a financial one. But the decision to avoid using daily leveraged ETFs shouldn’t be made based on poor information or cover-your-ass legalese.

Leverage can be a dirty word for many people. Some of the greatest investors condemn it (while using ample leverage themselves), people get stung by leverage, and anyone considering daily leveraged ETFs has inevitably come across legal warnings about daily leverage in volatile markets on the ETF provider websites. This includes recommendations to only use daily leveraged ETFs for short-term trading.

But the truth is nearly every person in a developed market is exposed to leverage. The concept is simple. If you borrow money to buy something, you are using leverage. Bank loans, mortgages, lines of credit, margin loans, and business leasing are all forms of leverage.

Leverage is a powerful tool. But it can be powerfully good or powerfully destructive. Just like people lost their houses in 2008-2010 due to poor use of leverage, you can wipe out your portfolio with poor use of leverage. On the flip side, responsible leverage can help build enormous wealth. There is not a single great investor I can think of who didn’t use leverage.

Some basic knowledge of leverage is only the first step in understanding daily leveraged ETFs. But a basic understanding of any complex subject is often more dangerous than not understanding the subject at all. For example, a basic understanding of electrical safety or food preparation is good—don't mix electricity and water, don't store food between 4C and 60C; however, a basic understanding of religious doctrine or stock trading is not. That is how we get destructive religious cults and people who blow up their trading accounts.

Many investors have a basic understanding of leverage and don’t see any issues with businesses borrowing to expand operations or people borrowing to own a larger home than they could otherwise purchase. That seems normal. But taking on leverage for trading or investing introduces a mental degree of separation. It adds another level of sophistication and complexity in an often already volatile world.

In truth daily leveraged ETFs are more sophisticated than most publicly listed stocks or common ETFs. Daily leveraged ETFs often involve derivative instruments called swap contracts and they may hold futures contracts. Swaps are similar to retail traded CFDs, but they are typically more customized for the needs of the parties involved. This means there is counterparty risk involved. A good ETF will have multiple swaps with different counterparties to reduce this type of risk

A daily leveraged ETF is also more risky than a standard ETF because it involves the use of leverage. If the underlying market moves 0.5 percent in a day, a 2x daily leveraged ETF will move approximately 1.0 percent, and a 3x daily leveraged ETF will move approximately 1.5 percent. We know that percentage movements to the downside hurt more than equal percentage moves to the upside.

The general pattern of returns that we see in equity markets introduces a trade-off when using daily leveraged instruments. Of the movements in equity markets, the largest daily moves tend to be on the downside; this causes an outsized amount of damage to the value of daily leveraged ETFs. Further, choppy markets of roughly equal size moves to the upside and downside hurt daily leveraged funds.

However, it's not all bad. Low volatility trending periods benefit leveraged ETFs more than their leverage implies because of daily rebalancing. Also, by their design, daily leveraged ETFs cannot go down to $0 in value. They may go down to $0.00001 (without unit consolidation), but never $0.

This added sophistication and risk in the instrument itself is all the more reason to use them carefully. When placed in a properly constructed portfolio for capital efficiency and risk reduction (yes… I mean less risk), daily leveraged ETFs are awesome.

The more one looks into them, the stronger their use case becomes for long-term holdings as part of a regularly rebalanced portfolio. These ETFs are not just for day trading. In fact, that's probably a very poor use case for leveraged ETFs—except maybe commodity ETFs that suffer significantly from rolling costs.

By simulating historical returns for daily leveraged funds, including fees and dividends, we can easily compare a standard 60/40 portfolio (S&P 500/short-term bonds) to a similarly performing portfolio that uses leveraged ETFs. The results are surprising.

On first glance an individual with almost no knowledge might assume that the investor would need at least 20 percent of their portfolio in a 3x leveraged ETF to equal a portfolio with 60 percent in the S&P 500. An individual with a basic understanding of the characteristics of these funds would assume even more exposure would be necessary to make up for the higher fees and oft-discussed volatility penalties of these funds. They would both be wrong.

When simulating a 3x daily leveraged S&P 500 fund back to 1950 an investor needs to invest under 13 percent of their portfolio in the 3x leveraged ETF. The remaining 87 percent can be invested in bonds, generating ample interest income and adding huge amounts of stability to the portfolio.

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis

While the portfolio generally lagged a bit in uptrending periods (don’t forget that stock exposure is sitting at 13 percent x 3—somewhere around 39 percent), the portfolio suffered a peak drawdown of just 20.9 percent. That compares with a 35.5 percent drawdown for the standard 60/40 portfolio.

Daily leveraged funds in small, carefully sized doses add to the safety of portfolio. Smaller drawdowns, less volatility, and less money exposed to risky assets.

What are you willing to risk by avoiding leveraged ETFs for the long haul?

Comments & Questions

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Financial Housekeeping for Moving Abroad

The last couple weeks have been a whirlwind of selling of stuff, packing what's left, moving the packed things, saying "goodbye" to our awesome friends in Edmonton, and traveling. All this to say things have been busy.

We took a 10 day trip to visit our friends in Toronto. I've never been there before and it has a lot to offer. If you haven't been, go visit Niagara Falls (the Canadian side)! We also took in a Blue Jays game (where they stomped all over the Orioles), visited Barrie and the Flying Monkeys Brewery, and enjoyed the South Asia Festival.

While I admit Toronto is a cool city to visit, the traffic and sprawl are quite insane. Our friends were sharing prices for houses, semis, and condos in different areas of the city. My god, I don't know why anyone would ever buy there. It's a ticket to financial destruction! Not to mention poking your eyeballs out driving in endless gridlock traffic day-in and day-out. If you want to buy a house and enjoy your life with much shorter commutes, move to Calgary or Edmonton folks!

Currently we are in B.C. visiting family and friends on the west coast (where house prices and financial madness are no better than GTA). We go to B.C. twice a year on average, so this will be the less touristy part of our trip. In about a week we will be flying out of YVR en-route to Hanoi.

Daily Banking

Some of the things I've been working on between the traveling and busyness is arranging our banking accounts for our move. A few months ago I opened up a Tangerine account and shifted most of our banking to the orange folks. (I was with an Alberta credit union before.) Since Tangerine is all online and fees are low, we will be keeping this account when we are overseas.

I must say I've been very impressed with Tangerine—especially considering they are owned by a big bank (Scotia) and I otherwise try stay away from the oligarchs. Customer service over the phone has been great, the app is clean and a pleasure to use, and the process of setting up our bill payments and deposits is easy. If you are banking with the big guys and are paying monthly fees, you should seriously consider switching. If you do, a free way to say thanks to me is by using my Orange Key: 55884598S1. We will both get around $50 from Tangerine as a thank you. (You have to use the Orange Key in the sign-up process.) As an aside, thanks to everyone who used my Questrade referral code! It has paid several hundred dollars so far, helping cover the costs of webhosting this blog.

I've also opened up a Borderless account with Transferwise. This is another awesome application that will allow me to move money across linked accounts (including Tangerine) and change currencies for extremely low fees. I was hoping to get a Mastercard debit card from Transferwise sometime this year, but it seems they have quietly put that program on hold in Canada.

I anticipate my wife will be opening a local account in Vietnam for local spending (a portion of her salary is paid in Vietnamese dong). Whether or not we can move Vietnamese dong out of the country (via Transferwise), or another compatible currency like Euros or British pounds remains to be seen. I know there are problems with U.S. dollar transfers.

Investment Accounts

As I've mentioned in prior posts, my wife and I will become tax residents in Vietnam effective on the date we land in Hanoi. This is based on the Vietnam tax code and their tax agreement with Canada.

Our RRSPs look like they won't be a problem. We can continue to invest within our RRSP accounts (including Locked-in RRSPs/LIRAs) as we always have without any additional tax repercussions. Questrade allows full access for expats and non-residents. We won't make any new contributions to our RRSPs though; there won't be any income earned in Canada which we can deduct the contributions against. With no new contributions for a while, I don't need to worry about currency changes; in the coming weeks I will switch these over to U.S. dollar accounts.

Our pensions will be partly moved into LIRAs and partly paid out (the excess portion). Neither my wife nor I have received our pension packages yet, so I don't know what their impact will be on our new worth. However, I anticipate it will be relatively substantial and I will not be leaving the money in the pension plans.

The payout will be made to us as foreign residents so it will be subject to a flat 25 percent tax. This might seem high, but it is important to remember that we contributed in the 30.5 and 36 percent tax brackets. Even if we remained residents in Canada, the excess portion would be taxed as regular income less any RRSP contributions we made. It is highly likely that the payout would be taxed at rates higher than 25 percent.

Unfortunately Vietnam doesn't recognize TFSAs as being tax free. I'm not sure if or when we would return to Canada as residents, so at the end of the month I will be moving money out of our TFSAs and into our regular investment account. This means we will be shifting more money from investing in Dual Momentum towards trend investing.

I'm looking forward to this move as it will play a key part in improving our overall capital efficiency. In our regular investment account I would love to get to 90 percent bonds (mostly short-term). I'm not precisely sure how this will look as I'm trying to find the best ways to allocate capital with tools like options and futures. But I do believe it will be doable while being tax efficient.

Taxes

In order to legally leave Canada, we will be paying a sizeable tax bill. All of our assets will be deemed disposed on the day we leave and taxed at their current fair value. This means some capital gains taxes will be owing. But I suppose that's the price to pay for moving to a much lower tax jurisdiction where our taxes should be much lower going forward. Pay now, save a lot more later.

As mentioned above, we'll also be paying taxes on pension payouts. This would happen inevitably with quitting our jobs, but the costs will add up nonetheless. With RRSPs, time will be on our side. We can keep them indefinitely and let them grow, or withdraw them at a 25 percent tax at any time once we are out of Canada. For now I'll keep them in place, mindful that any gains are effectively subject to a 25 percent tax while I make up my mind.

Taxes in Vietnam will be much lower than in Canada. Particularly on investment income and returns. Using UCITS funds (mainly listed in London), we can buy bond funds and have a low 15 percent withholding tax on interest income while also eliminating estate tax exposure. In Vietnam our tax rate on the interest income will be just 5 percent. The only other investment tax we need to worry about is effectively a sell-side transaction tax of 0.1 percent on equities and publicly traded instruments.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com