A.I.M. Users Bulletin Board

[ls7550]

Hi SFSecurity

... article that argues that 2X ETFs are a better deal than 3X.

http://ddnum.com/articles/leveragedETFs.php

I'll have to re-read it to see...

re-read near the bottom ...

This article has not proved that the optimal leverage is about 2. It has just demonstrated that 2 has been good in the past. The future may be different.

The argument that costs make a difference can be considered by looking at LETF's as not providing 3x or whatever the price change, but rather 3x the volatility. Scale to a common volatility such as half the amount in a 2x as a 1x (or a third of the amount in a 3x as a 1x), and if the 3x ETF's costs/fees are comparable to 3x the 1x ETF's costs/fees, then they're comparable on the costs front.

You can use a backtest tool such as this to then compare the relative difference between what the LETF paid to borrow in order to scale up stock exposure, and what might have been earned in bonds.

Some take it even further, for example XIV (inverse volatility) can be like a 5x stock holding. Zvi Bodie takes it further still and holds Traded Options that equate to 10x stock (he targets 10% in Options, 90% in TIPS).

Rebalancing is a must to avoid tracking error (after a sizeable move the % stock exposure will have shifted relatively higher or lower). 10/90 highly speculative (Options)/safe as per Bodie provides the optionality to time such rebalancing. If for instance stocks are collapsing and the 10 speculative is wiped out, then deferring rebalancing avoids drawing down the 90 safe side and limits your losses to <10% assuming those bonds earn a positive return. Similar to having sold out of the market after a modest/moderate decline ... waiting to buy back in again (100% 'cash'). Get that timing anywhere near right and the leveraged upside rebounds can be very significant (like compounded gains being repeatedly added in until you rebalance again to de-risk that).

A reasonable choice IMO is to use Ocroft's type trading (actually buy (rebalance) after a series of AIM monthly buy signals stops), AND use the vWave as a guide of target 1x weightings/exposure to rebalance to. If for instance vWave had originally been suggesting 66% cash, 33% stock and you held that as 11% in a 3x; And later Ocroft AIM type signal indicated monthly AIM had stopped buying the decline whilst vWave had perhaps shifted to 33% cash/66% stock, then you adjust to 22% in the 3x. If that timing was reasonable and stocks entered a strong rebound recovery, perhaps rising 50%, then the 3x held over that period might rise > 3x that rise (perhaps 5x). Scaled higher and a 5x (or Bodie's 10x) might rise (compound) significantly more than their respective 5x (10x) levels.

I've held leveraged positions long term 'buy and hold' for years now to good effect. I've mostly 'retired' however and simply rebalance when sizeable deviations from target weightings have become apparent i.e. predominately just using leverage to track the 1x, but benefit from tax efficiencies by using leveraged compared to holding the 1x. A annoyance is that you have to jump through hoops to trade them. For instance last time I sold some I had to do a online quiz to ensure I was a sophisticated investor aware of the risks associated with leverage, with a 28 cool off period if you failed (before you could retake the test). I complained to TD about that, saying it was ridiculous to have such a test when selling already held stock ... but their response was poor ... suggesting that if the test was failed and you couldn't sell held stock electronically then investors could always use their (more expensive) telephone dealing in order to make the sell held stock trade. In general leverage has received such bad publicity its becoming increasingly difficult to utilise in a sensible manner. Options require larger deposits, LETF's are being targetted to be scaled down to being no more than 1.5x ....etc.

Regards.

Clive.