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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Long and Short Trend Systems

Trends in financial instruments are extremely interesting. A certain trend-based model can provide consistent outsized returns in some applications, but when the same model is applied to a different market those outsized returns may vanish quickly. Likewise, similarly constructed trend-based models that vary only in duration of trends can have wildly different results on the same market.

On the one hand this may tempt us to create different trend models for different markets, but on the other we know it's dangerous to data mine results for a backtest. This type of period specific data mining can provide catastrophic results moving forward.

Over the past few weeks I have been looking carefully at complex trend models applied to a range of markets. This includes focusing on shorter-term trend models, longer-term trend models, blended trend models, long/flat applications to trend models, and long/short applications to trend models.

Trend Models on Equity Markets

When I want to do a long backtest on an equity market, I am generally confined to the S&P 500. This is the only market where I can get free daily or weekly data on that extends back to 1950. From there, I can get Nikkei 225 data from 1965, NASDAQ Composite data from 1971, FTSE 100 data from 1984, Russell 2000 data from 1988, and so on.

Unfortunately MSCI and FTSE keep a pretty tight lid on daily data from their more popular international indices: the MSCI EAFE, MSCI Emerging markets, FTSE Developed ex-U.S. and FTSE Emerging markets index.

Aside from being the most popular stock index in the world, this is why we see the S&P 500 being used as the example market in nearly every model published on the internet blogs. This includes my little writing project.

Long/Short Trend Model (Short-term)

Short-term trend following is very profitable in certain time periods. While it can appear highly technical and advanced, or at least difficult for your average self-directed trader to implement, it has become a lot easier with developments like the E-mini futures on major indices.

In this subsection I've simulated a long/short trend model on the S&P 500 (price only) using trends which are shorter in duration. I took more than 80 trend measurements ranging from 2.5 weeks through 3 months. These were derived into a factor ranging from -10 through +10. If the factor was -10 the investor was fully short; if the factor was +10 the investor was fully long.

A trader in the late 1980s who ran a long/short fund on S&P 500 going back to 1950 using a model like the one described above looked like a genius. It generally performed very well from early 1960s, but importantly it got you on the right side of the 1987 crash. Investors with any sense would have poured money into your hands.

Credit: TheRichMoose.com, Standard & Poors

Since 1987 things have not gone that well for this strategy applied to the S&P 500. The nature of the market seems to have changed after 1987 and the exact same model substantially underperformed the S&P 500 as seen below.

Credit: TheRichMoose.com, Standard & Poors

If you look at the poor performing chart more closely, there are moments of apparent brilliance. In September and October 2008, this single system would have returned nearly 40 percent. This is very aligned with the performance seen by some of the short-term trend equity funds at that time (often amplified by leverage).

Long/Short Trend Model (Long-term)

As one might predict, when we move to longer duration trends on the S&P 500 index the backtest becomes more stable. This is mainly because transitions from fully long to fully short occur more slowly.

In this subsection the trend durations used are much longer. Again I took over 80 different measurements of trend that ranged from 3 months through 12 months. I derived these into a factor ranging from -10 through +10. When the factor was -10 the investor was fully short the S&P 500; when the factor was +10 the investor was fully long.

Unlike the short-term trend strategy, this long-term strategy didn't have any long periods of outperformance relative to the index (except the period from 2000 until 2009 using peak-to-trough measurements).

Credit: TheRichMoose.com, Standard & Poors

The brief moments of massively outperforming the index were quite fleeting. This strategy saw a peak 55 percent jump in 1973-1974, a peak 45 percent jump in 2001-2002, and a peak 75 percent jump in 2008. On the surface this looks like amazing downside protection, but these short periods of outperformance were quickly followed by underperformance.

A quick spike up immediately followed by a quick drop is not a desirable or sustainable solution to portfolio construction. It's all but impossible to try ride the climb up only to get out before it drops down.

A rolling return average demonstrates the sharp moves in the long/short model relative to the index quite clearly. It also shows the sustained underperformance compared to the index.

Credit: TheRichMoose.com, Standard & Poors

Short-term vs. Long-term Trend Model

When we compare our short-term trend model to our long-term trend model, we can see a massive divergence and shift in overall market conditions post-1987. The long-term trend model began to outperform and just 10 years later had pulled ahead of the short-term model.

Credit: TheRichMoose.com, Standard & Poors

Summary

Applying complex trend models to an equity index like the S&P 500 can show some clear differences in how markets behave in short trends and longer trends.

We can see a pretty clear shift in how the S&P 500 behaved (and could be traded profitably) prior to 1988 and following this period. Before 1988, a short-term trend system that traded the S&P 500 both long and short was extremely profitable.

Since October 1987, short-term trends applied to the S&P 500 in the same manner would have performed very poorly. I don't have the necessary data to determine if the profitable period between 1960 and 1987 was an anomaly, or if the market shifted in nature after 1987. Either way, a short-term strategy that went long and short the S&P 500 after 1987 never again saw those great returns in any sustainable way.

Long-term long/short trend systems on equity markets can show impressive profits in downtrending markets. But it would be difficult to realize and hold onto those gains when the market reverses course. We saw this play out in 1973-1974, 2002, and 2008.

In future posts I will apply my trend model to long/flat strategies in the S&P 500 and other equity indices. I also hope to do the same with several of the major currency pairs.

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