A.I.M. Users Bulletin Board

[ls7550]

Leveveraged Funds will " IMPROVE " volatility. Or at least increase it

That's what they're in effect designed to do. They should have been marketed as such IMO. Volatility eats average gains (same average yearly gain with less volatility yields higher compound average growth). 2x will average around twice the volatility as the 1x, 3x averages three times the volatility. Since January 2009 SPY (1x) had a standard deviation of 13.4%, SSO (2x) stdev = 27%, SPXL (3x) stdev = 41.4%. Other than over a single day they will NOT provide 2x or 3x the gains. However if you de-scale the volatility, such as holding half the amount in the 2x as you would in the 1x, then both the (annualised) rewards and stdev tend to compare.

They're useful for some in that they can be more tax efficient. And they provide a means to rebalance without having to sell bonds. If for instance I have $100,000 of stock exposure held in a 1x and wish to increase that to $120,000 long stock exposure whilst holding $140,000 in bonds, you can sell $20,000 of 1x and buy $20,000 of 2x and keep the bonds as-is (that might be in fixed term). Then when bonds do mature you can readjust again perhaps to eliminate the 2x holdings.

Other uses include squeezing more of long stock exposure into limited tax exempt/efficient space (especially if bonds can be held tax efficiently). And de-risking counter party risk ($100,000 with a single counter party 1x holdings might be reduced to $33,333 held via a 3x).

Don't forget however that stocks are typically leveraged anyway. Something like a broad average 1.75 equity/debt ratio. Leveraging that up yet further is obviously a risk. If you offset that by de-leveraging elsewhere in around equal amounts then the overall risk remains similar. A problem however is that some misuse leverage and max out such, which is a common cause of sudden/rapid bankruptcy.

Conceptually each of price appreciation, dividends/interest and volatility capture gains should all compare. If that were not the case then investors would focus in on the most rewarding choice. Typically Options traders target rewards from volatility. Some investors target dividends/interest, others look to price appreciation (growth). Diversifying across all three, price appreciation, income, volatility/trading is a reasonable approach.