Exaggerated Tracking Error Fears for Leveraged Funds

Daily leveraged funds are still quite new to the retail investor. The first 2x leveraged ETFs tracking broad market indices started trading in the middle of the last decade.

Just a few years later, anyone investing in these ETFs who was not sure about their performance in all market conditions was rudely woken. The largest 2x fund tracking the S&P 500 suffered from an 85% drawdown in the 2008-09 Financial Crisis. That's correct, every $1,000 in this ETF shrank to a mere $150.

Since that time, the you've heard the warnings over and over. From the financial news, your run-of-the-mill financial advisor, most financial blogs and online sources, and even the large and prominent disclaimers on fund provider websites.

Like this one directly from Horizons Canada's website:

"The ETF uses leverage and is riskier than funds that do not. The ETF seeks a return, before fees and expenses, of +200% or - 200% of its Referenced Index for a SINGLE DAY. The returns of the ETF over periods longer than ONE DAY will likely differ in amount, and possibly direction (of the performance, or inverse performance, as applicable) of the Referenced Index. Longer periods AND/OR greater volatility will make the possible divergence more pronounced. Investors should monitor their investment in this ETF daily. Please read the prospectus and ensure you understand this ETF before investing in it."

The prevailing wisdom is simplified to this: leveraged ETFs are very, very risky. They are only for use by a professional day trader who watches their brokerage account throughout every trading day. Do not hold leveraged ETFs unless you want to lose your money.

What Does the Data Say

For a few years now I've been quite skeptical of these claims. It is only logical that daily leveraged funds of reasonably stable indices should outperform their underlying index over longer periods of time, even after adjusting for fees.

I believe the argument made by the crowds is an oversimplified one. Certainly a leveraged daily fund will not provide an exact specified multiple return over the underlying index for any period greater than one day. Volatility guarantees that. Large down days do damage, while positive returns over numerous days compounding each day provide outsized returns.

However, it's time to debunk the myth of danger surrounding these funds. Over the past weeks I've compiled a large spreadsheet of daily returns for the S&P 500 since the beginning of 1950. Then I simulated the annual performance of daily leveraged funds from 1950 to 2017.

In the 68 calendar years of data I compiled, a 3x daily leveraged fund would have returned a 2.5x or higher multiple of the S&P 500 in 53 of those years. Further, an another 11 years would have still been a positive multiple of the index, although less than 2.5x.

This means in 95% of all years in more than one-half of a century, a 3x daily leveraged fund would have returned a positive multiple of the S&P 500.

In just four years the annual return was negatively correlated to the underlying index: 1960, 1987, 2011, and 2015. The pattern in each of these four cases is quite similar. In 1987, 2011, and 2015 the stock market had a correction which occurred near the end of the calendar year. In 1960, the market was just very up and down from start to finish. In 1960, 2011, and 2015 the S&P 500 was just barely positive on the calendar year, so the negative multiple return of the leveraged fund would not have had a substantial impact on the investor.

The only year where the 3x leveraged fund would have a large negative impact was 1987. As most investors with some knowledge of market history know, 1987 was a memorable year. In a single day, October 19, the U.S. stock market experienced its largest daily fall ever with a -20.47% return. On a 3x daily leveraged fund, that translates to a single day return of -61.41%. As you would expect, a large daily loss of this magnitude takes time to recover.

However, if it's any consolation, in four years since 1950 a 3x leveraged fund would have returned more than 4x the underlying S&P 500 index thanks to the power of daily compounding of positive returns: 1953, 1954, 1958, and 1990.

Summary

The data shows that a daily leveraged fund performs according to its expected return over the course of an entire calendar year more than 80% of the time. This is a high rate of success and shows that in the vast majority of market conditions daily leveraged funds on broad market indices are not significantly impacted by the historic market volatility.

In the past 67 years, there was only a single year where holding daily leveraged funds of the S&P 500 would have negatively impacted a investor to a substantial degree because of volatility induced tracking error. I believe it's safe to say 1987 was a unique year in stock market history that is not likely to be frequently repeated in the future.

While all investing with leverage carries risks that are amplified when not used properly, the common wisdom that leveraged ETFs should be used for short-term or day trading only is misplaced. Under the vast majority of market conditions throughout history, the divergence of daily leverage when held for longer periods of time is not substantial.

Always remember when the underlying index enters an extended drawdown, the effects of that drawdown will be amplified with daily leveraged ETFs. This is common and should be expected. Despite their simulated tracking history over long time periods being better than commonly held beliefs suggest, it would be reckless to allocate the majority of your portfolio or tax-advantaged account within your broader portfolio to a leveraged ETF.

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Risk Management for Speculators & Trend Investors

Risk management is the absolute key to success for speculators and trend investors. If you can limit your losses and downsides, the upside will take care of itself.

Here are a number of rules to help you reduce risk in your trend investing portfolio.

1. Divide your total portfolio equity into equal sized portions.

Ten portions is good to begin with and you can expand to twenty equal portions as your portfolio equity grows and you gain access to more markets. Unless you are managing millions, there is no point into dividing your portfolio further. Keeping your portfolio equity portioned will help with setting risk levels and stop losses for each position later. It is also a good way to help you determine the number of markets you should monitor and trade.

 

2. Only put up to one portion of your portfolio to work in any one asset.

By limiting your bet size on any one asset, you are ensuring your portfolio stays manageable from a risk perspective and properly diversified for broad return potential. You never know which markets are going to make you your profits, so don't bet the ranch on just one or two assets. Cash, or short-term bonds, are a default holding so nearly your entire portfolio may be in cash if markets are not trending.

 

Example Assets Only

3. Trade diverse markets that provide returns which are independent of each other.

Trading only stocks and bonds will not provide you with a broad range of returns. Instead, monitor a range of uncorrelated and liquid assets: stock indices, currencies, precious metals, real estate, and bonds. If your account is larger and you have access to futures markets, include energy, grains, and industrial metals.

A lot of these assets can be traded with ETFs, but be careful to pick the right ones. You want liquidity and reasonable costs.

 

4. Determine the size of each position, including leverage, based on volatility.

Leveraging up your position can help increase returns on each position, but it also increases your chances of hitting a stop loss quicker than you need to. This can increase your whipsaw costs. Use Average True Range or Standard Deviation to measure the volatility of an asset. The asset's stop loss price should be a low multiple of ATR or SD.

Your stop loss price will help you determine an appropriate size for each position once leverage is factored in. Based on this formula, a highly volatile asset might be purchased with no leverage, or maybe less than a full position. Many assets can be leveraged up 2x to 5x or maybe more.

 

5. Never risk more than 2% of your current portfolio equity on any one asset.

Regardless of the size of the position and the amount of leverage used, the maximum loss of any trade should never be more than 2% of your portfolio equity. Newer and more cautious investors should start with a 1% maximum risk per trade. In dollar terms, if your portfolio equity is worth $100,000, your maximum equity loss on any of your positions should not be greater than $2,000. Limiting losses is the key to long-term success.

Source: Flickr - DoD News

6. Enter a Stop Limit Order on every trade set at your maximum risk.

To ensure your emotions don't get in the way of your trading, always place a stop limit order on every position. The stop price should be set at or near your maximum risk. Assuming you are risking 2% equity per position on a $100,000 portfolio, your stop price will never allow your total equity loss on any position to exceed $2,000. Move your stop loss up as your position becomes profitable, but never move your stop loss down.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.