Friday, March 30, 2012 10:20:31 AM
Leveraged ETF's will typically scale up exposure to 2x (twice) or 3x the underlying assets DAILY price moves.
Some investors expect leveraged funds to compound (annualise) to 2x or 3x the 1x (underlying) returns - BUT THEY DON'T. Not by a long way.
To understand why, this image helps
Annualised gains are what you can actually eat. Average gains are just a mathematical value. And annualised gains are a function of the average gain and the standard deviation (volatility). Generally leveraged funds will scale up the average gain AND THE STANDARD DEVIATION, and a higher average with a higher standard deviation typically works out to a lower annualised than what might perhaps others have been expected.
As an example consider an average gain of 10% with a standard deviation of 20% (which is perhaps quite similar to stocks in general). That produces a 8.2% annualised gain.
Three times scale that, such as what a 3x leveraged ETF might endure and a 30% average with a 60% standard deviation produces a 15.3% annualised. i.e. a 3x leveraged fund didn't even produce twice the underlying assets gain during a rising stock price phase. For anyone who's interested I have a web page that includes such a calculator located at http://www.jfholdings.pwp.blueyonder.co.uk/cagr.htm
In the opposite direction, in a poor stock performance period, a -10% average with a 20% standard deviation annualises to a -12.3% loss. Scale that up 3x and a -30 average, 60 standard deviation annualises to a -64% loss.
Understanding such compounding issues with leveraged funds is a long way towards understanding why they shouldn't generally be used other than for short term trading purposes, such as perhaps buying a short 3x fund to hedge a portfolio if a SHTF event becomes apparent.
It's not all doom and gloom for leveraged funds however. Used wisely and they can be a good longer term buy-and-hold asset to own. For example scale down a 3x leveraged ETF to replicate a 1x and leveraged ETF's can be good. Instead of perhaps investing $100,000 in the Dow you might invest $33,333 in UDOW (3x leveraged Dow) and deposit the remainder $66,666 in a shorter dated treasury (cash) holding and achieve somewhat similar rewards to had you invested $100,000 in the Dow. If rebalanced daily to keep the ratio of UDOW and Cash to 33.3 : 66.67 ratio levels, typically that will track the Dow very closely. The costs (expense ratio) for leveraged ETF's is usually high, but as you only hold a third of the amount in that it scales down the cost relative to the actual total amount of funds being invested.
If you rebalance less frequently than daily, as is sensible as otherwise trading costs would be overwhelming, you will see some tracking error. But that can be either beneficial or negative, in around equal probability and amounts (so neutral overall).
What has more recently attracted me to actually using leveraged ETF's as buy-and-hold investments, is that they offer additional features that wouldn't otherwise have been available. As a UK investor if I buy a US 3x ETF then that in effect provides exposure to 100% of the stock price risk/reward, 33% of the USD/GBP currency change risk/reward, and 66% of the cost of borrowing negative/positive real interest rate risk/reward. Whilst those risk/rewards can swing either way - for or against you, it is exposure to risk that generally produces rewards over time.
A 3x leveraged ETF's typically will in effect borrow an additional twice the amount that you actually deposit with them. If I invest $20,000 in a 3x Dow ETF, then that fund borrows another $40,000 and invests the total $60,000 into the Dow (very generally speaking). At times, the cost of borrowing can be lower than inflation and having borrowed some funds can be a good thing i.e. the cost of that debt is eroded in real (after inflation) terms by inflation. Typically the cost that funds have to pay to borrow isn't that dissimilar to that amount that you earn on shorter dated treasury's, so in having invested one third of your investment amount in a 3x fund and deposited two thirds in cash, you're in effect covering the costs that the fund has to pay to borrow. If instead those two thirds of funds are invested elsewhere and that provides a better return than short dated treasury's, then that adds value to the overall rewards that you achieve (equally however if those 'cash' funds lose relative to short dated treasury's then you're worse off).
Another good aspect of leveraged funds is that they have a floor. If I invest $10,000 into a 3x leveraged fund and that underlying (1x) crashes by more than -33.3% then my loss is limited to $10,000 when otherwise having instead invested $30,000 into the 1x might have lost $15,000, $20,000 or more.
Understanding and using leveraged ETF's wisely can be an appropriate choice of asset. Mostly however there's bad press about leveraged ETF's as more commonly most articles only consider how closely or not the leveraged ETF's replicate the scaled UP 1x underlying over extended periods of time, whilst totally ignoring how closely the scaled DOWN exposure to leveraged funds replicate the 1x (not forgetting to also account for the amount of funds invested in cash that would otherwise have been invested in the stock). In effect beating the underlying stock when using leveraged ETF's distils down to beating cash (cost of borrowing).
Some investors expect leveraged funds to compound (annualise) to 2x or 3x the 1x (underlying) returns - BUT THEY DON'T. Not by a long way.
To understand why, this image helps
Annualised gains are what you can actually eat. Average gains are just a mathematical value. And annualised gains are a function of the average gain and the standard deviation (volatility). Generally leveraged funds will scale up the average gain AND THE STANDARD DEVIATION, and a higher average with a higher standard deviation typically works out to a lower annualised than what might perhaps others have been expected.
As an example consider an average gain of 10% with a standard deviation of 20% (which is perhaps quite similar to stocks in general). That produces a 8.2% annualised gain.
Three times scale that, such as what a 3x leveraged ETF might endure and a 30% average with a 60% standard deviation produces a 15.3% annualised. i.e. a 3x leveraged fund didn't even produce twice the underlying assets gain during a rising stock price phase. For anyone who's interested I have a web page that includes such a calculator located at http://www.jfholdings.pwp.blueyonder.co.uk/cagr.htm
In the opposite direction, in a poor stock performance period, a -10% average with a 20% standard deviation annualises to a -12.3% loss. Scale that up 3x and a -30 average, 60 standard deviation annualises to a -64% loss.
Understanding such compounding issues with leveraged funds is a long way towards understanding why they shouldn't generally be used other than for short term trading purposes, such as perhaps buying a short 3x fund to hedge a portfolio if a SHTF event becomes apparent.
It's not all doom and gloom for leveraged funds however. Used wisely and they can be a good longer term buy-and-hold asset to own. For example scale down a 3x leveraged ETF to replicate a 1x and leveraged ETF's can be good. Instead of perhaps investing $100,000 in the Dow you might invest $33,333 in UDOW (3x leveraged Dow) and deposit the remainder $66,666 in a shorter dated treasury (cash) holding and achieve somewhat similar rewards to had you invested $100,000 in the Dow. If rebalanced daily to keep the ratio of UDOW and Cash to 33.3 : 66.67 ratio levels, typically that will track the Dow very closely. The costs (expense ratio) for leveraged ETF's is usually high, but as you only hold a third of the amount in that it scales down the cost relative to the actual total amount of funds being invested.
If you rebalance less frequently than daily, as is sensible as otherwise trading costs would be overwhelming, you will see some tracking error. But that can be either beneficial or negative, in around equal probability and amounts (so neutral overall).
What has more recently attracted me to actually using leveraged ETF's as buy-and-hold investments, is that they offer additional features that wouldn't otherwise have been available. As a UK investor if I buy a US 3x ETF then that in effect provides exposure to 100% of the stock price risk/reward, 33% of the USD/GBP currency change risk/reward, and 66% of the cost of borrowing negative/positive real interest rate risk/reward. Whilst those risk/rewards can swing either way - for or against you, it is exposure to risk that generally produces rewards over time.
A 3x leveraged ETF's typically will in effect borrow an additional twice the amount that you actually deposit with them. If I invest $20,000 in a 3x Dow ETF, then that fund borrows another $40,000 and invests the total $60,000 into the Dow (very generally speaking). At times, the cost of borrowing can be lower than inflation and having borrowed some funds can be a good thing i.e. the cost of that debt is eroded in real (after inflation) terms by inflation. Typically the cost that funds have to pay to borrow isn't that dissimilar to that amount that you earn on shorter dated treasury's, so in having invested one third of your investment amount in a 3x fund and deposited two thirds in cash, you're in effect covering the costs that the fund has to pay to borrow. If instead those two thirds of funds are invested elsewhere and that provides a better return than short dated treasury's, then that adds value to the overall rewards that you achieve (equally however if those 'cash' funds lose relative to short dated treasury's then you're worse off).
Another good aspect of leveraged funds is that they have a floor. If I invest $10,000 into a 3x leveraged fund and that underlying (1x) crashes by more than -33.3% then my loss is limited to $10,000 when otherwise having instead invested $30,000 into the 1x might have lost $15,000, $20,000 or more.
Understanding and using leveraged ETF's wisely can be an appropriate choice of asset. Mostly however there's bad press about leveraged ETF's as more commonly most articles only consider how closely or not the leveraged ETF's replicate the scaled UP 1x underlying over extended periods of time, whilst totally ignoring how closely the scaled DOWN exposure to leveraged funds replicate the 1x (not forgetting to also account for the amount of funds invested in cash that would otherwise have been invested in the stock). In effect beating the underlying stock when using leveraged ETF's distils down to beating cash (cost of borrowing).
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