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Re: Toofuzzy post# 38164

Thursday, 09/18/2014 4:36:07 AM

Thursday, September 18, 2014 4:36:07 AM

Post# of 47129
RE : LETF's

Hi Toofuzzy.

Leveraged ETF's by themselves across a uptrend will tend to scale up rewards. A 3x daily for instance might rise 4x the 3 month underlying index price change. In effect the LETF is adding more exposure after each up move, less after each down move. They can also drop less than 3x during across a down-trend, perhaps 2.5x instead of 3x the move. Tracking such relative moves and buying in at lows (when the mid term tracking has deviated to quite a wide spread) can provide a reasonable entry timing signal.

For actual trading/investing in general, I find that the 2x is about the best choice however to actually hold. Half in 2x, half in bond over any one year period will reasonably track the underlying over that year long period. In rebalancing once/year however that means the bonds can be locked in - there's no liquidity issue.

A 5 year ladder of bonds when each rung is held to maturity will reward somewhat close to the average of the rolling 5 year yields (not marked to market) and have one rung maturing each year. If you coincide the 50/50 2x/bond holdings with such bond maturity then bonds are earning the 5 year yield whilst the LETF is paying overnight lending rate to provide leverage. Generally that cost of providing leverage incurred by the LETF fund will be lower than the 5 year treasury bond yield. That spread helps offset other costs/taxes.

As a simple example a 2x Dow LETF might invest your deposit in the Dow stocks and then borrow the same amount again at 0.5% cost of borrowing to buy more Dow stocks so that you're holding 200% exposure of your deposited amount. If that's half of your total allocation and the other half is invested in 5 year yields that pay 2% interest, then there's a 1.5% difference between what the fund is paying to borrow and what you're earning from bonds. The LETF might have 0.6% fees/costs and with 50% exposure to those fees = 0.3%, whilst the lend/borrow (bond) spread = 0.75% (relative to the total portfolio amount) = 0.45% benefit. The Dow stocks might be paying 2% dividends and 15% tax might be deducted from that = 0.3% tax, which the 0.45% benefit offsets (and more in this case i.e. overall +0.15%).

If there is a big drop in the Dow and the 20% of bonds maturing from one rung is insufficient to cover how much more LETF needs to be added, then generally the next bond rung being 1 year from maturity will be relatively close to its par value/price in having just 12 months remaining to maturity.

Compared to the alternative of holding the underlying (1x) I find that is more expensive on a net basis. 0.1% fee, 2% dividend and 15% tax = 0.3% for a total -0.4% lag of the index gross total return. If instead you're achieving a +0.1% premium above the index gross total return = 0.5%/year more reward. A modestly small amount - but over time that can compound out to a sizeable difference.

The benefit (higher reward) is reflective of the additional risks. There's the counter-party risk for instance - the institute that the LETF might hold the swap with. There's also interest rate risk as a 5 year ladder will lag tracking interest rates upwards (but hold on to higher yields for longer when interest rates are declining). And under periods of high interest rates the cost of borrowing might be more than 5 year yields (inverted yield curve - generally the yield curve does tend to be less often inverted, but when it is the spread can be quite wide). For many it wouldn't be worth the bother. Even at $1M invested for instance if you're making 0.5% more = $5000/year 'wage' for the efforts required to manage the positions - or perhaps less, for instance Vanguard might charge just 0.07% fee, benchmark to the NET return that might be 15% less dividends than the index, and then outperform the benchmark, so perhaps lagging the gross total return index by maybe 2% dividend minus 15% tax = 0.3% plus 0.07% fees = 0.37%, but through good management (perhaps some benefit from share swaps etc) maybe reducing that to a 0.2% lag of the gross total return index. Equally however you might take on more risk and trade the 50% bond allocation, and perhaps enhance rewards of the 50/50 LETF/bond holdings. Personally I play it that way myself as there are often better alternatives to treasury 5 year yields that have relatively low additional risk (high street bank 5 year bonds for instance that are in effect insured by the state - but that yield more than 5 year treasury bonds. Those however might be fixed term, no early withdrawal, so in the event of needing perhaps the maturing and next bond ladder rung amounts to top up LETF exposure you'd have find some alternative source of funding to maintain the position (such as swapping some holding into a 3x LETF)).

Not applicable to me, but I believe another benefit of rebalancing in the US would be that pushes any gains into being long term (>1 year) rather than short term, which I believe are taxed differently in the US (???).

etfreplay.com is quite a good web site to have a look at such positions. From their main page select the "backtesting" dropdown and then the "ETF Portfolio" option and perhaps enter a allocation of something like SSO 50%, TIP 50% and compare that to SPY (the default) over different single year periods.

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