Leveraged ETFs for the long run*
For MOGULS by Finumus
on July 27, 2023
Let’s be clear: leveraged ETFs are hyper-controversial and not well understood. Nevertheless, in forthcoming articles from the Finumus camp about gearing up a portfolio and investing for different generations I intend to talk openly about them.
Hence I want to spend today explaining how they work. That way – with all the blood and gore out and on the table – we can hopefully in future have a grown-up conversation about their use.
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Great article, looking forward to the whole series!
One question: Eyeballing the graph, it looks like the WisdomTree efficient core fund does a lot of work just to end up with very similar returns (and volatility) to the S&P500. Is this a blip because of the recent poor performance of bonds?
Anyway, would be interesting to see some models of how it ought to behave in various combinations of returns/volatility for the underling assets.
Did we have a visit from m’learned friends with that massive disclaimer? Makes me yearn for the innocence of “Here be Dragons” on ancient maps. Or maybe Dante’s “Abandon all hope, ye who enter here” 😉
Thanks for the excellently written, clearly explained, fascinating and informative piece @Finimus. I had a very strong prior against leveraged ETFs before reading your piece, but I am going to try and keep an open mind as your series unfolds. In a slightly bizarre coincidence, I’d ranted against leveraged ETFs just 24 days ago at comment #27 on the thread to an old (Oct 2014) Monevator article on, of all things, the Momentum factor:
https://monevator.com/momentum-premium/
You will see at the previous comment in that thread (#26) @Algernond described leveraged ETFs as “scary..they can move against you quickly, and have horribly large spreads”, to which I’d responded with my comment about not touching them “even if wearing a Hazmat suit and using a bargepole attached to another bargepole”. But reading your piece now, I think that I may have been just a little too easily swayed by what I’d read previously against leveraged ETFs, in particular by TEBI’s two pieces critiquing them (which I’d linked to in my comment #27 in that thread). I think you’ve given a very fair and balanced take today on these often controversial, typically complex and sometimes misunderstood products. Buffett said something to the effect once that, if you’re smart in how you invest, then the only way that you can go really seriously wrong is with using excessive leverage. But of course he had the free float leverage of GEICO to deploy. So, even he could see a valid role, in practice, for appropriately scaled leverage if it was available on good terms. And if I squint past some of the horror shows thrown up by 2x, 3x and even 5x leveraged ETFs with highly volatile underlying indices, then I think that I can just about make out a possible useful role for something like the Wisdom Tree U.S. Efficient Core Fund. Being 1.5x long a plain vanilla 60/40 strategy could be a good place to be if the costs were right (and 20 bps does look OK), and providing of course that there is no hidden trapdoor of risk to catch out an unwary soul. I am very much looking forward to the rest of the articles in your series and thank you again for this one.
I think Finumus makes two key points that I think are really important to appreciate.
First, that nothing is special about a leverage factor of 1. The portfolio is not somehow safe when unlevered (leverage factor 1) but unsafe at a leverage factor of 1.1. People seem to think leverage is somehow “wrong”. Risk is what matters, not leverage. I can be 3x levered and be far less at risk that someone who is unlevered. It depends on what/how I invest.
Second, the rebalancing bonus is in many ways the flipside of the volatility drag. In options, it’s gamma vs. theta. This is all just convexity (non-linearity) vs. negative carry. You typically don’t get a free lunch. I run my portfolio to collect “rebalancing bonuses” across a very large number of strategies. It’s also why I don’t just do equities or bonds. Not enough dimensionality to generate those rebalancing bonuses. I seek out complexity to generate more rebalancing.
What I don’t see though is why you would use levered ETFs from the usual suspects. What can they do for me that I cannot do myself? Why not just use futures/option structures? Anyone who understands levered ETFs well enough to use them, probably can do this themself more effectively.
Just got head around Shannon’s Demon via the RQA link kindly provided in the article. Astonishing and counterintuitive stuff, & appropriate Shannon also played a key role in solving paradox of James Clerk Maxwell’s entropy defying demon.
@ermine — Unfortunately the massive disclaimer has to be there for various reasons. Including the fact that the 1% of people who would blindly follow something off the Internet without doing their own research, thinking about their own situation, or properly understanding (and weighting the chances) that things can and do go wrong also have a high overlap with the sort of people who will blame someone else for their own mistakes. 🙁
@Time Like Infinity — Yes it’s something isn’t it. I’m trying to remember where I read a lot about Shannon in an unrelated investment book. I want to say the Ed Thorpe bio…
@all — Very quiet comment-wise on this post despite a healthy uptick %-wise in Mogul members since the last post! I’m sure @Finumus won’t call you out in the next article if you say something that causes him umbrage like I did… 😉 (Well okay, I’m not sure, but most of you are anonymous so what harm can he do. And he means very well anyway haha.)
@TI. I’ve made a few comments over the last week that have never appeared. To be fair, those comments didn’t add much so it might be for the best but is there any chance stuff is getting lost in the aether?
I think Finumus makes two useful points. First, that there is nothing special about a leverage ratio of 1. People seem to get very bothered by leverage but what really matters what format that leverage is in. I can easily take a position that is “3x levered” but is in reality far less risky than something totally unlevered (leverage ratio 1). A 5 x levered ETF can still only go to zero. Being long the 5x levered ETF vs short the ETF can have nice properties in certain scenarios.
More important point is the issue of “the rebalancing bonus” vs. “volatility drag”. It’s just another variation of convexity vs. negative carry. Or in options, it’s gamma vs. theta. I was taught early on not to diversify across asset classes, countries etc but to diversify across strategies. You want a portfolio with as high a dimensionality as possible. If you do, they you can collect a large amount of “rebalancing bonuses” or whatever you want to call it. The end result is a far higher Sharpe ratio with basically no market view. It’s the core of both my professional and personal portfolio approach. Locating those mean-reverting parameters is the skill.
It’s really at the heart of why I dislike the equity-bond portfolio as a concept. People seem to like it because it is simple. The problem is simple has no dimensionality. You should be maximizing complexity, not trying to reduce it.
Apologies for posting yet again. Is there anyway @Finimus for UK investors to get around PRIIS to access more sensible end of leverage spectrum i.e. NTSX? Question overlaps with basically same issue with BKLC & SCHA for SIPPs in your cheapest global ETF portfolio article.
Thanks Finumus for this and the “how low can you go” article. I’m studying it intently as it’s time to move from Ftse100/prefs/default Sipp funds to something closer to your global list.
If there’s any material improvement in the funds please can you us all know – I know non of it’s advice
Ps TI, I’m reading the “own the world” book from last weeks reading, a good book for 99p, nice easy read.
Thank you for the great article.
I’ve dabbled in these products occasionally but have settled on investment trusts for my long term holdings to get levered equity exposure. Several of these (FCIT, Mercantile, etc) have taken out long term debt at fixed rates of 2% or lower in recent years. And with discounts at record levels, you can get this exposure cheaply (at least compared with historic discounts). You are of course taking on active stock selection risk, but the fees on several of these are quite reasonable (sub 50bps), so offer a quite compelling alternative to levered ETFs without the volatility drag.
@LondonYank. I don’t think you can really compare the small amount of leverage in a typical investment trust with say 2-3x leveraged ETFs (LETFs). Moreover, LETF are function of daily return changes. It’s better to think of a LETF as a series of forward starting 1 day total return swaps (1d, 1d-1d forward, 1d-2d forward etc). The long-term returns are a function of that daily compounding process.
What it is fair to say though is that LETFs are somewhat niche in terms of their specific application. You have to decide whether an LETF is a better manifestation of what you are attempting to achieve vs. alternative such as futures, option or even funds with some level of leverage. My own take is there are specific applications where I have found them useful but, generally, I find option structures more parsimonious (cheaper, less resources used, more easily customized).
So, in conclusion, leveraged ETFs come at 30x the cost and are a great long term investment if one picks an index that will rally spectacularly. Otherwise they are a disaster.
I’ll go polish my crystal ball then.
Actually, 30x the cost may be a gross underestimate. We’re at a ~5% risk-free rate, so why would anyone lend for less than 6%? No free lunch, right.
So, for a 2x leveraged ETF:
– 3% p.a. financing cost
– 2.5% volatility drag (average assumption)
– 1.5% management and hidden fees
That’s 100x the cost of a normal ETF. I’d rather have a go at roulette.
#8 to #12: I’m well outside both my own comfort zone and circle of competence on LETFs, so please do excuse the ignorance of my question here. Might there be some circumstances where you could exploit different pricing mechanisms of options v LETFs, when coupled with measures to try and tilt the field of play in your favour, by exploiting Shannon’s Demon in those situations where volatility drag is most likely to be overcome? Say you wait until volatility is low and option pricing cheap (e.g. VIX below 15). Select 2 LETFs out of the index based LETF universe which have the highest relative momentum (on 6 month look back period), provided that they each have both positive absolute momentum (over whole 6 months) and also positive accelerating momentum (1+3+6 month returns). Implement a static stop loss at 20% below purchase price. At same time, buy a put option on the indices covered by the 2 selected LETFs. Because of past momentum, might be a decent chance of getting over volatility drag, which itself should have a higher than average chance of being lower because of buying LETFs only when vol lower. If it goes pear shaped, stop loss takes you out at 20% loss. With luck, the put pays out sufficiently to cover both it’s premium and some significant proportion of that 20% loss. On the other hand, if the selected 2 LETFs’ past momentum persists and overcomes vol drag; then the return from them could cover the put premium. Frankly, I’ve next to no idea what I’m talking about on this here, but any thoughts would be gratefully appreciated.
@Sparschwein. My last two comments to you never appeared so will try one last time. I take your point on LETFs being expensive but there are scenarios where they can be useful. Personally, I prefer options, but others may prefer LEFTs or inverse LETFs. I assume Finumus will get to those applications in later posts.
I think this article makes two useful points. First, that an unlevered position (leverage ratio 1) is not special. It’s perfectly possible to have a 3x levered position that is less risky than a 1x levered in some scenarios.
Second, that negativity around LETFs is often focussed on the “volatility drag”. This is not fair. That drag is the flipside of the “rebalancing bonus”. It would be like focussing on option theta decay while ignoring the gamma. It’s typically true that any positive non-linear (convexity) type effect has adverse negative carry.
My own portfolio is set up to collect as many “rebalancing bonuses” as possible. To do that I deliberately maximize the complexity of my portfolio (in terms of dimensional degrees of freedom). I find sets of negatively correlated products with similar volatilities. I basically then harvest the mean-reversion. It’s far easier than deciding whether something goes up or down. I do need to manage the negative carry.
@ZXSpectrum48K:
Thanks for flagging, I’ve found all your (very useful as per) comments in the auto-spam (i.e. I never saw them) and have restored them to the site.
I don’t know why this is happening or what to do about it. You’re the second poster for whom this has happened. If anyone else has had this experience recently, please flag and I’ll have a root around.
(For context there are 4,453 comments in ‘spam’ right now and they are regularly automatically deleted 😐 )
It used to be an issue sometimes if links were included but there are no links in your comments.
I’ll dig around and see if there’s some way I can adjust the sensitivity.
p.s. Perhaps we should duplicate the slightly repeated comments @ZX, do you have one you’d consider the canonical version?! 🙂
I for one am very grateful for each and all the different versions of ZX’s comment(s). As with the articles from @Finimus, those comments give insight into worlds of high finance which are otherwise practically unaccessible to retail, DIY semi-passives like myself. I sometimes feel a bit like someone with a decent grip on basic mental arithmetic who is then confronted with the mathematics of string theory, but the only way to learn is by challenging yourself with something new.
Had similar issues to ZX with comments occasionally going into the digital void and, bizarrely, also one instance where comment appeared with its middle section missing. I think it might possibly be partly a network issue rather than just a spam filter one because the page refresh got stuck after clicking Submit.
@TLI — Can’t see any comments from you in Spam right now 🙂
@TI. There is no canonical version. I just tried different lengths until one got through the system. In the 10 min edit, I made it longer and it survived. So that seems the strategy to use.
Just delete #13 and #17 if possible. Too much of me makes me feel sick so what it does to others I don’t want to think about.
@ZX – very interesting comments as always and I’ll keep an open mind to learn how the pros use these ETFs, with risk control and all.
The article seems to suggest to go levered long-only on stock indices for the long-term (so multiple years, in my understanding) to harvest the equity risk premium. I just don’t see how this fits into a sensible portfolio beyond a few edge cases (take a punt for the kids, a civil servant with a large DB pension…).
TI, on the weekly reading last week I tried responding in Jam twice, but neither appeared. Not sure if it was spammed or not relevant
@Boltt — Found it, restored. Apols. This is very frustrating. I can’t currently see that I have an option other than to spend 15 minutes twice a day going through the Spam folder looking for errors. I suppose that might yield a pattern.
Great to see some heavy metal investing ideas, I mean why have caffeine when you can have cocaine?
Joking aside, QQQ is my biggest holding, and I’ve held the legendary QQQ3 briefly – in a small amount along with 3x Nvidia IIRC. Thankfully out of both before the drop in ’22.
In terms of ‘leverage’ my thinking now is to start with a couple of options – firstly borrow against the safer portfolio asset – so a 60/40 becomes a 70/30, no margin needed. Secondly, add a % of correlated higher vol/return index to produce the same effect – so if you are in global equity mainly – add a proportion of S&P500/QQQ. No guarantee, but similar, without the extra carry. After that well there is an argument for LETFs…in moderation. They are costly but the limited liability is great.
On the S&P/bond version one issue is that its open to the risk of the fourth quadrant bond/equity slide as you say.
Looking forward to the next part. And thanks @ZX for persevering!
@Calculus #24 “why have caffeine”: opening the Moguls’ email on Thursday and seeing the words “Leveraged ETFs” was like momentarily hallucinating being on wallstreetbets’ Reddit in Jan 2021. But, seriously, having gotten head somewhat around the daily rebalancing effect and Shannon’s Demon, and with revelation that there are arguably some sensible products in the LETF space, such as the WisdomTree US Efficient Core Fund; perhaps I was being unnecessarily and/or overly leveragaphobic before reading this excellent and thought provoking article from @Finimus.
@Finumus – excellent as always.
@ZX “Personally, I prefer options”…I’m considering setting up some long dated deep ITM call (LEAPS) – say at ~220 on the SPY expiring Dec 25 at today’s levels (thereby getting a 2X long). I see this as having lower carrying costs (loss of dividend of ~1.5% p.a., time decay of ~1.5% p.a., bid ask spread of ~50bps – for a total of 3.5% p.a. costs). This doesn’t benefit from rebalancing.
Any problems you see with this structure? Do you use options differently?
There’s some quite aggressive LETF momentum strategies out there, but only those with a rapid / hair trigger risk-on to risk-off switching mechanism seem to claim any degree of success over longer timeframes. Here’s an example from Seeking Alpha today (with useful links to the Portfolio Visualiser results in PDFs):
https://seekingalpha.com/article/4625213-combined-leveraged-and-non-leveraged-etfs-tactical-allocation
@TLI #27, Nice, although I’d go 3X Short QQQ on Risk-Off periods for the win 🙂
Note a lot of the growth came in a short period round ’19-’21 .
One could use a DCA strategy to soften the market timing requirement.
@Calculus: Because of the PRIIS rules, I don’t think that any of the listed LETFs or ETFs referenced in the three Pdfs can be brought in the UK. Best guess is that the quick switching mechanism from risk on and risk neutral to risk off would be as important as relative momentum for both LETF and ETF elements.
@TLI I’ve been able to buy some on HL eg LQQ3 recently, after going through a box ticking exercise, so would think a comparable set of ETF options could be found.
Interesting. Thanks @Calculus. Wonder what other platforms can offer? While the LETF sector is super high risk (expect that the risk exposure scales to some exponent of the leverage factor used), such that it’s a lot (lot) easier to end up turning £10 into 10p as to turn £10 into £1,000; I couldn’t find even the plain vanilla, unleveraged US listed broad market tracker ETFs listed on a UK platform.
Apols @Calculus: now seeing that there’s actually several UK listed equivalent LETFs (often Wisdom Tree) to the US listed ones (often Direxion or ProShares).
There’s much worse examples of LETF underperformance than ProShares Ultra 3x Oil, given as example. WisdomTree Natural Gas 3x Daily Short (GBP) (3LGS) shows 5 yr high to low range (eyeballing its HL chart for high fig, and taking low from past year summary) of eight orders of magnitude. Ridiculous. Must be some sort of record. Time & again LETF charts show almost total wealth incineration. V. few go up & to right. Even 3x Nividea is down 2/3rds on its LETF ATH, in contrast to stellar performance of underlying share. Unless v. confident in using strong momentum filters to time buy/sell, LETFs, as available to UK investors, still looks like shooting self in the foot; notwithstanding magic of Shannon’s Demon.
@ZXSpectrum48k – My first comment may not have posted, trying again.
“Personally, I prefer options”…I’m considering setting up some long dated deep ITM call (LEAPS) – say at ~220 on the SPY expiring Dec 25 at today’s levels (thereby getting a 2X long). I see this as having lower carrying costs (loss of dividend of ~1.5% p.a., time decay of ~1.5% p.a., bid ask spread of ~50bps – for a total of 3.5% p.a. costs). This doesn’t benefit from rebalancing.
Any problems you see with this structure? Do you use options differently?
SSRN research “Alpha Generation and Risk Smoothing using Managed Volatility” (Tony Cooper, Double-Digit Numerics) covers what it calls the “Myth about Long Term Holding of Leveraged ETFs”. It’s accessible even to non-mathematicians like myself:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1664823
optimizedportfolio.com also covers common ‘defensive’ model allocations but using LETFs, including Dalio’s All Weather and Browne’s Permanent Portfolios.
Currently just 7 out of 79 LSE listed LETFs on Morningstar’s ETF comparison page (available under the Monevator Tools link at the top of this page) have positive one year returns. That’s really awful. Equally bleakly, many are down close to 100% in just a single year. So it might be helpful to reproduce here the short LETF disclaimer at optimizedportfolio.com:
“I’m not a financial advisor and this is not financial advice. It’s for informational and recreational purposes only. Products discussed are for illustrative purposes only. This is not a recommendation to buy, sell, or transact in any of the products mentioned. Do your own due diligence. Past results do not indicate future performance. Research and read up on the fundamentals of leverage and the nature of leveraged ETF products before blindly buying in. It can potentially be a very dangerous game. Using leverage increases the potential for greater returns but also the potential for greater losses. The use of leverage increases portfolio risk, and investors face a real possibility of losing all money invested. Specifically with leveraged ETFs, these are relatively new, exotic products that behave differently than “regular,” unleveraged index ETFs. Do your due diligence and read the fine print. Similarly, don’t put your entire portfolio in a strategy like this. If you want to play with something like this, do so with a small piece of your total portfolio, and definitely not with money you’ll need in the next 5-10 years.”
@Time like infinity
Yeah, I read that paper when it was published. And indeed volatility targeting is a pretty useful concept, although a little beyond the scope of my post.
The fact that pulling up a list of ‘all’ leveraged ETFs and seeing that most have lost a lot of money, is TBH, not a particularly helpful observation. As I noted in the article – most of these things track assets that are wholly inappropriate for the application of leverage. That doesn’t mean that they are a bad idea if applied to an asset that’s more appropriate.
Very good point @Finumus#36, and really enjoyed the article BTW. Thank you.
Yes, return stacking. Leveraging on top of volatile underlying assets. Bad idea, but not because of either layer per se but instead because of the combination of both. Felt like I had to put in the warning to my last post though, as these are the LETFs actually available on the LSE. Not intending to knock the premise that there could be good uses 🙂
At the moment there seem to me to be perhaps 3 ways that LETFs could work:
1). Something like the WisdomTree efficient core fund, or a slightly less leveraged version of the optimised portfolio LETF version of the Dalio All Weather defensive allocation.
2). Apply absolute (and relative?) momentum to the actually available (2x or 3x) lower spread LSE LETFs with sensible underlying broad equity indices (basically limits to NASDAQ and SP500 LETFs at 3x on most platforms). Rebalance frequently. Maybe put in a 15% stop loss.
3). Possibly the ‘Hedgefundie’ 3x LETF idea with 55% SP500 and 45% long Treasuries, rebalancing quarterly, as (oddly) first appeared on Bogleheads, and whose performance is one of the LETF portfolios tracked by the dual momentum systems website.
Interesting paper: “Leverage for the Long Run – A Systematic Approach to Managing Risk and Magnifying Returns in Stocks”:
(2016 Charles H. Dow Award winning paper, updated through Dec 31, 2020), Michael Gayed:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2741701#:~:text=Michael%20Gayed,-Lead%2DLag%20Publishing&text=The%20critical%20question%20of%20when,be%20beneficial%20to%20using%20margin
@All: Now found a Seeking Alpha piece referencing both LETF papers mentioned above at #35 and #38:
https://seekingalpha.com/article/4226165-trading-strategy-beat-s-and-p-500-16-plus-percentage-points-per-year-since-1928
And a reddit subthread with links to an amateur backtest of the MA200 leverage rotation strategy with 3x Nasdaq:
https://www.reddit.com/r/LETFs/comments/mdb4n4/backtesting_tqqqs_hypothetical_performance_over/?rdt=56500
Bogleheads has a very long forum (split into 2 parts) on the HEFA, or Hedgefundie, 3x (55% in S&P500 + 45% in 20 year US Treasury Bills) strategy mentioned at #37 above here:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=272007
Portfolio Optimizer have also covered this idea more briefly on YouTube.
There’s also a few Reddit threads covering LETFs generally and Michael Gayed’s 200 days’ moving average strategy specifically, mostly it seems focused on replacing the 3x S&P 500 LETF with a 3x NASDAQ 100 one. Examples linked to below:
https://www.reddit.com/r/LETFs/comments/mdb4n4/backtesting_tqqqs_hypothetical_performance_over/?rdt=37491
https://www.reddit.com/r/LETFs/comments/mfugvt/trading_letfs_upro_tqqq_etc_using_sp_200day/?rdt=39641
https://www.reddit.com/r/LETFs/comments/ybt07y/tqqq_discussion_letf_experts_come_forward/
https://www.reddit.com/r/LETFs/comments/sdx8sm/buy_tqqq_sell_at_qqq_200_sma_8770_gains/
This is very much for information only. I most certainly am not recommending, and never would recommend, any of this.
Leverage is very high risk indeed, even if and when it works.
It’s also worth noting here that there’s no circuit breaker on the NASDAQ exchange I believe, so a fall of anything more than 33% in a day would be a 100% wipeout with a 3xNASDAQ LETF – i.e. zero remaining capital.
On 19th October 1987 the S&P 500 fell 20.47% in a single session, so a fall of more than 33% in a day for a major index or exchange is actually quite possible.
Thinking about @Sparschwein’s comment #13 on the financing costs for LETFs and realised that this also plays into an obvious, but nonetheless rather striking, feature of using leverage in different interest rate environments.
The 3x leveraged HEFA portfolio I linked to above on Bogleheads is a good example of this.
If you follow the suggested shortcut at the start of the long Bogleheads thread to the strategy backtest for 1955 to 2018, then you’ll see the strategy (which is basically just a 3x 60/40, or more accurately, in the modified version, a 3x 55/45) performs disappointingly up to 1981 (due mostly to catastrophically poor performance from the leveraged bonds), but from 1981 to 2018 the strategy turns right around and performs amazingly (although the Sharpe and Sortino ratios are still not all that brilliant).
So far so expected. The relentlessly rising rates environment from circa 1965 to 1981 would have absolutely hammered leveraged bonds. And from 1981 to 2018 the leverage would have magnified what was overall a good time for both stocks and for bonds.
However, the performance figures may not take into account sufficiently the sometimes rather massive costs which would have been unavoidably embedded into the leverage financing, as @Sparschwein alludes to.
At the moment rates are 5%. In 1981 US rates were over 15% for T-Bills. Similarly, in the UK, the equivalent of the base rate in 1979 hit 17%. If leveraged products like LETFs had been available in those times then they would have carried a funding cost at a margin over those rates. This would have created a huge hurdle for the product performance, had such products then existed.
It’s not clear to me that the Bogleheads’ backtest, or indeed any hypothetical multi decade backtest of leveraged ETFs, has made (what to me seems the necessary) assumption that the real world funding cost would – at times – have been much higher than the financing costs faced by such products since their launch in the 2010s, and indeed now.
If that’s correct, then I think it should mean that the performance figures would be worse that the existing backtesting suggests.
OTOH, by parity of reasoning, a falling rates environment should not only be a higher performance era for bonds and stocks with perhaps lower volatility (which helps leverage to work) but also one where the funding cost to use leverage compresses over time, thereby giving a tailwind of sorts to the leveraged versions of those asset classes.
Re: my point on financing costs @#41: The Dual Momentum Systems’ site, which I mention above @ #37, has a number of strategies using LETFs which it tracks, all of which are inspired by Gary Antonacci’s original Dual Momentum idea (which is unleveraged). The highest performing (LT Gain ++, simulated CAGR of 23.77% since 1980) for example invests in the Russell 1000 via an unleveraged ETF where the index shows positive momentum and in unleveraged Long Term Treasuries when it does not; unless the index falls 15% month on month, in which case it goes 3 x long the S&P 500 for one year using an LETF. The maximum leverage is therefore 300% and since 1980 the average leverage used has been 145%. In the small print to the monthly performance updates I now receive from DMS it states “Leverage ETF data is used as far back as it is available, it is simulated using available daily return total data to extend the leverage returns back in time. At this time, only the leveraged S&P 500 from 1970 through 1979 had to be simulated on monthly data instead of daily”. There appears to be no indication though that the simulated LETF performance for periods preceding the launch of the LETF accounts for the financing costs in earlier periods being different (and sometimes substantially so) to the actual finance costs post launch. This is, IMO, likely to significantly impact the strategy performance figures in the backtesting; potentially calling into question the usefulness of the simulated data. As noted in #41 above, this seems to be an issue common to pre launch period backtesting for LETFs, which of necessity has to use simulated data.
Erratum: although I can’t find a clear expression of its rules, I now think that the leverage trigger for LT Gain ++ is actually a 15% drawdown from the last ATH as measured at the end of each calendar month.
If it was a 15% month on month decline trigger then there would historically have been very few instances where the trigger would have been triggered, and I doubt now that is what the strategy intends.
FWIW – WisdomTree have just launched a UK listed, UCITS version of their 90/60 US Equities / Bonds strategy ETF. It appears _not_ to be swap based, which is far from ideal from a dividend WHT point-of-view. But still.
https://www.wisdomtree.eu/en-gb/etfs/efficient-core/ntsx-wisdomtree-us-efficient-core-ucits-etf—usd-acc
Many thanks @Finumus. Trading 212 have it. Hopefully likes of ii, AJB and HL will soon follow. Had been wondering how to do a DIY leveraged 60/40 now the bond crash may be behind us. Some UK Bogleheads evidently have had similar thoughts:
https://www.reddit.com/r/HFEA/comments/sf8117/poor_mans_approach_to_ukbased_modified_hfea_in_a/?rdt=47471
@TLI – Just to confirm, HL is letting me trade these leveraged (& inverse) ETFs in my ISA & SIPP after I ticked some boxes. I’ve (foolishly?) started to use them in my ETF MTM strategy. Looks like Interactive Investor will also.
Interactive Brokers though are another story. They refuse to let me buy them in my ISA, even though I’ve told them on more than one occasion that HL & II allow it (they’ll allow in trading account though it seems)
Many thanks @Algernond. Much obliged for the heads up. Good to have you as a Mogul! 🙂
Inspired by Allan Roth’s etf.com piece in Saturday’s Monevator weekend reading links, I’ve realised that there might be a way for a subset (probably quite small subset, but I’m potentially in it) of people to, in effect, de-risk doing either:
– a LETF S&P 500 with 200 days’ SMA trend following risk on/off strategy (targeting lower volatility drag for use of leverage); or,
– a fixed LETF 90/60 S&P 500/Treasuries strategy;
with a part of their portfolio.
It relies on either already having enough in a SIPP to meet retirement needs (with a sensible SWR) or in having a good DB pension to meet minimum retirement requirements (or some combination of the two).
To do it you work out how long you have until you retire.
You then buy UK listed US TIPS ETFs or TIPS directly in a SIPP (and/or in a ISA) to try to match their duration to the years you have left to retirement. The chart in the Roth piece covers this nicely.
At the moment it is possible to do this at real inflation adjusted yields of about 2.5% p.a. These are amazingly good real rates, all guaranteed by Uncle Sam.
I personally thought during the ZIRP/QE years in the 2010s that we’d never again see the like of real rates on TIPS like we have now.
The amount (as a % of the portfolio) of TIPS that you buy is determined by the time left in years to your retirement.
This should guarantee you a US $ amount of purchasing power equal to the whole value of your portfolio now.
With the rest of your portfolio you can then do LETFs.
If the LETFs go to zero (the worst possible case) then the TIPS if held on to maturity should still cover in real terms the starting value if the portfolio (i.e. at the time of the investment into TIPS and LETFs).
Obviously, in that worst case then you have only maintained and not grown the value of the portfolio in real terms, and then only in $ not £, so there’s the chance, depending upon the exchange rate, that in £ you could be better or worse off, even though you would have held the real terms value of the portfolio measured in $.
However, $/£ exchange rates are not massively unstable, even over years, and especially when they’re adjusted for purchasing power parity.
Trying to do this idea with ILGs rather than TIPS currently means sacrificing a whole percentage point of real returns as the highest real yield on index linked gilts (other than very shortly maturing ones) is only a little over 1.5% p.a., which greatly reduces the percentage allocation left over in the portfolio to aggressively go for growth using LETFs.
As I say, this only works for those who’ve already got enough in the SIPP and/or a DB pension to meet their retirement income needs at the time they intend to retire.
Re #47 above: T10G.L ETF (UBS Bloomberg Barclays TIPS 10 year + UCITS ETF hedged (GBP), with an adjusted duration 14 years and an OCF of 0.25% p.a.) and TI5G.L (the iShares $ TIPS 0-5 years UCITS ETF (GBP) hedged (Distributing), with an OCF of 0.12% p.a.) might be of interest to anyone wishing to hedge TIPS’ currency exposure. Holding different balances between the two ETFs would, I think, give a different average duration to maturity for their combined holdings enabling rebalancing into a target retirement date (i.e. starting with the long duration TIPS ETF and each year reducing the allocation to that and increasing the allocation to the short duration one). I’m far from sure though that this would have the same effect as a TIPS ladder. Perhaps someone with more understanding of this than me can assist?
FWIW over at Bogleheads I see a “Alpha4” has come to a similar conclusion as mine on historical leverage costs on one of the many threads there, stating: “Did that Python simulation back to 1980 include the actual cost of leverage as well (not just the simulated ER but the actual assumed cost to borrow so as to go 2X or 3X long each day)? If not, it will severely overstate the returns during any period that isn’t low/zero interest rates (ZIRP) like we basically had from 2009 to 2016 or 2017. Rates were very high from 1979 to 1984 or so”.
At Bogleheads there’s also some interesting threads on using leverage, including this one on a fairly complex risk parity type approach: “Hydromod’s Okay Adventure: Leverage, Momentum, and Risk Management”.
You may see that I’ve v. recently created a Bogleheads profile as TLI in order to ask a question of a ‘Logan Roy’ under the “Re: 60/40 vs. Golden Butterfly for Retirement” on a rather spectacular set of backtests, which may or may not involve leverage.
Got a little further sense of what the ‘steady state’ LETF funding costs might be like over the longer term in a lower rate environment.
Unsurprisingly, for US equity and US Treasury bond leveraged ETFs this seems to be a function of the overnight US dollar LIBOR.
When $ LIBOR was at all-time lows a few years ago then, for the 3x S&P 500 US listed UPRO LETF and for the 3x 20 year US Treasuries US listed TMF LETF, their funding costs were apparently:
TMF LETF costs ~= 2 * Overnight LIBOR + Expense ratio
UPRO LETF costs ~= 2 * Overnight LIBOR + Expense ratio
I’m thinking that LETFs can work for a high return low volatility asset class during times of relatively low volatility for the asset (which means tactical asset allocation is needed) and when interest rates are low so funding costs are surpressed. Lower rates also function as an asset class price tail wind.
Having strong positive momentum / trend and, for equity based LETFs, a large ERP would also be likely to be extremely helpful.
In case it’s of any interest, over at Bogleheads one seemingly knowledgeable and plausible poster describes back testing leveraged allocations using the Dartmouth Kenneth French dataset across 10 industry sectors, US Treasuries, gold and the S&P 500 from 1926 to date, using post 1995 and pre 1940 as out of sample. Across ~500 million random portfolios brute force tested via the wonders of modern computing, the one with the greatest out of sample persistence of outperformance was (drum roll):
– 27% Consumer Nondurables (i.e. Consumer Staples) LETF with x3 leverage
– 27% Healthcare LETF with x3 leverage
– 26% Energy LETF with x3 leverage
– 10% Intermediate Treasuries with x3 leverage
– 10% Gold with x3 leverage
Unfortunately, I don’t yet have details of the rebalancing frequency used to reset the fixed allocations between asset classes and industry sectors. As the Bogleheads poster notes, it does bear (if one squints hard enough) a passing (albeit a not especially striking) resemblance to a 3 x leveraged version of Harry Browne’s Permanent Portfolio. I don’t think it’s possible to actually reproduce this in the UK. There are, as far as I can tell, no 3x LETFs for all the asset classes and all the industry sectors used (and the PRIIS regulations bar accessing US listed products).
A new piece of quantitative finance research each day helps to keep the brain rot away; on which note, James DiLellio, an Associate Professor of Decision Sciences at the Pepperdine Graziadio School of Business in Malibu (a nice gig if you can get it) has a paper from 2018 on SSRN titled: “Risk and Reward of Fractionally-leveraged ETFs in a Stock / Bond Portfolio”, and which is pretty interesting:
https://ssrn.com/abstract=3272532
Looking at LETFs on Investing.com, I think I’ve found a new candidate for the most absurd one, namely the ProShares Ultra VIX Short-Term Futures ETF (UVXY). The way that it relentlessly looses money has to be seen to be believed – it’s like watching water go down a plug hole.
And I’ve just come across this nicely compact overview of LETFs versus using margin (“Leveraged ETF Investing” by Tal Miller, March 2021):
https://arxiv.org/abs/2103.10157#:~:text=It%20is%20common%20knowledge%20that,margin%20debt%20or%20leveraged%2DETFs
The TL:DR is the paper, “perform[s] bootstrapped Monte-Carlo simulations of leveraged (and unleveraged) mixed portfolios of stocks and bonds, based on past stock market data, and show that leverage can amplify the potential returns, without significantly increasing the risk for long-term investors”.
Further to my #40: here’s the Reddit take on a UK HEFA LETF (30% 3x S&P 500 + 70% 1x 20 year US Treasuries):
https://www.reddit.com/r/HFEA/comments/sf8117/poor_mans_approach_to_ukbased_modified_hfea_in_a/?utm_medium=android_app&utm_source=share
I’m trying to work out if this is likely to outperform, underperform or perform about the same as the WisdomTree U.S. Efficient Core Fund (NTSX), which is at least theoretically now available in the UK. One is effectively leveraged 1.6x and requires quarterly rebalancing while the other needs no rebalancing and is leveraged 1.5x. One has 30% allocated into a high cost product whilst the other is ‘all in’ a lowish cost one. One is equivalent to a 55%/45% US stock/bond whereas the other to 60%/40%.
An early Christmas present further to both @Sparschwein (#12,13) and my #50 comments above.
This week (20 & 23 December) someone finally had a crack at working out what the actual effects of the LETF finance costs would be over the very long term using a simulation of 3x S&P 500 going back to 1913.
The results are in 2 articles found over at “howiinvest.com” respectively entitled “Backtest blind buying UPRO to 1913” and “1955 & 1913 LETF backtest”.
The methodology for the finance costs are described thus: “the SPXTR monthly return, multiplied it by 3, subtracted a 1% annualized expense ratio, and subtracted 2 times the ten year treasury yield…this isn’t a perfect calculation for a synthetic UPRO since institutions borrow at shorter term rates and the fund uses a daily multiplier not a monthly one. This is just a way among many of estimating and I have chosen inputs that will let us go back to 1913. The 2 year yield doesn’t go back that far in my data set.”
Basically, the simulated 3x LETF with B&H goes from massively outperforming the S&P to significantly underperforming over the full 110 years and, obviously, with very much greater volatility than the index.
Having said that, Tactical Asset Allocation with a Leverage Rotation System using a trigger of trend (e.g. 200 day SMA) and/or volatility (e.g. VIX below 25); and/or using DCA instead of lump sum investing; and/or only using LETFs when US 10 year Treasuries yield below a certain level, could each (and possibly even more so in combination) perhaps tremendously affect the odds of beating the S&P 500 using leverage (i.e. dumb Alpha plus leveraged Beta which is deployed only at certain quantitatively selected times could possibly equal an outperform).
@Finimus & @Time Like Infinity
It appears NTSX has now made its way onto AJBell, ii & HL.
Many thanks @SkinnyJames & wishing you & all Moguls a very happy & a very successful New Year.
NTEX/WTEF is a massively safer beast than a 3x levered equity index LETF like UPRO/3LUS or TQQQ/QQQ3.
Having said that, I must confess to fascination with the possibility (which at the moment is just at the research stage) of DCA-ing a small and capped portion of my ISA into a rules based Leverage Rotation System with 3x equity index LETFs using some combination of low VIX and above 200 day SMA.
However, it’s a very deep rabbit hole.
The one thing I am pretty confident of (apart from steer clear of anything inverse/short, and not based on an established mainstream equity index) is to ignore any research / modelling / backtesting which fails to explicitly account for all of the actual likely leverage funding cost for periods where the relevant LETF is simulated because the product had yet to be launched.
The funding cost has a really tremendous drag because it historically has been greatest at times when the simulated LETF performance would have been worse thereby compounding the downside and crushing the long term returns (whatever LRS system is used to target low volatility regimes and avoid high ones).
I’m now finding in my research that other people have attempted to simulate likely historic funding cost drag of leverage.
Over on Reddit at r/LETF one informed commenter (‘madnax_br5’) concludes as follows:
“Finally an accurate backtesting model
Disclaimer: I am not a financial professional, just a private investor looking to increase my knowledge. Nothing I say in this post should be construed as financial advice or assumed to be correct without independent validation. That said, let’s dig in.
I found that there are a few common backtesting errors that have significant material consequences:
* Using average rates for dividends and interest applied uniformly across the backtest.
* Levered funds are compounded daily, so the actual dividend returns and interest rate payments at a particular moment in time are very important to get as close to correct as possible, since they will compound with fund volatility to produce significant long-term effects. For example, although the average interest rate across a 20 year period might be 5%, It may have in actuality been 0% for 15 of those years and 20% for 5 years. If you just use the average of 5%, your fund will not compound correctly. Thus, is is best to use monthly interest rate data and actual dividends wherever possible, or as close as you can get. Using one average rate for the whole period can give you information about how different fund rates might affect long term performance, but will not be an accurate simulation of the historical period.
* Not using or simulating total-return data.
* Leverage is obtained through the use of total-return swaps, which compound both the underlying security’s price returns AND their dividends. Using the base index without accounting for dividends will produce an incorrect simulation.
* To correct this, you can use a data series that is already adjusted for total returns, but this can be hard to source. The other option is to find historical annualized dividend returns for the security and amortize this across each year you want to backtest. I tried both these methods and they both work. Having actual total-return data is very slightly more accurate, but using historical dividend returns year-by-year and merging this into the index data is a decent alternative.
* Ignoring returns from fund assets, such as interest and dividends.
* In addition to swap contracts, which are treated as liabilities, the funds have a mixture of assets that vary and may include cash, equities, and treasuries that accrue interest and dividends in their own right. You must look into the fund holdings and model the income sources from this asset mix, as even small returns can have a significant impact over long time periods.
With actual market rate interests above 10% in the 70’s and 80’s, this interest rate drag absolutely crushes levered funds. However, by plotting hypothetical interest rate scenarios, we can get a good sense of the break-even point on interest rates. That leads us to some useful observations and analysis:
* **Generally, when the federal funds rate is less than the index dividend rate, levered funds have positive carry and this compounds to your benefit. When the funds rate exceeds the dividend rate, levered funds have negative carry, which works against you. As a result it is probably good to be careful with levered funds for longer term periods when the federal funds rate is above \~4%, which it currently is! At the very least, the loss from interest rates will need to be hedged somehow to make it viable to hold these funds through volatile periods.**
* **Volatility decay for long market index funds is a myth as it manifests only in short term chop. It is later erased through positive compounding during periods of growth, assuming the index grows in the long term. We can see that these funds did not decay over nearly 70 years of often extreme volatility, even after being ground down to almost nothing during the dotcom and 2008 GFC. Edit: I should clarify that volatility drag is a real thing, it’s effects in levered broad market indexes just isn’t that significant in the long term thanks to periods of positive compounding.**
* **Because of decreased interest drag, 2X levered funds perform better than 3X for pure “buy and hold” scenarios. However, both lagged the underlying index for many decades due to the interest rate spikes in the 70’s and 80’s. This suggests that a blind buy&hold is not a sound strategy, and at a minimum, consideration must be given to periods of high interest rates, and stop losses or hedges to prevent deep drawdowns during market crises.**”
BTW apols for the length of the last post. Felt I should include the disclaimer from @madmax_br5 (just spotted I mistyped his/her tag), which I also adopt as my own here. LETFs are high risk and it’s essential to thoroughly do your own research and to proceed, if at all, with extreme caution.
Nice explanation of Shannon’s Demon here:
https://www.marketsentiment.co/p/shannons-demon
Absurdly late to the party here but on the off chance I’ll pose my question anyway…
I’m risking being the niggling nerd Finumus calls out in the post by focusing on bond carry in the WisdomTree U.S. Efficient Core Fund (NTSX) so just to emphasise I ask this in the spirit of seeking to understand it and not to niggle the idea !
I’m thinking about using this fund but not loving the negative carry on the bond futures. I’m wondering does it make sense to hold off entering this until the yield curve is upward sloping and you’re at least neutral on the bond carry or ideally a bit positive? Or is this just missing the point, forget whether its slightly positive or slightly negative carry its just there to smooth out the volatility?
Cheers for any thoughts !
@AoI I now hold some WTEF ETF (the UCITS version of the US NTSX). The spread is currently a bigger issue IMO than the carry. Hopefully, this will improve as the AUM rises.
If the S&P 500 and US Treasuries both manage to rally in price terms due to rate cuts, then it could be a capital efficient way to profit from both sides of the equity /bond split, but with possibly slightly less volatility than the stock side alone.
Of course, it could instead all go very wrong, and I certainly haven’t got any clue whatsoever as to what will perform well (and what won’t) next. As always, DYOR etc applies and neither investment advice nor recommendation etc.
With the 3x LETFs, and their associated market timing strategies, it does seem quite a bit like “the Devil’s card game”, as covered today on the Market Sentiment Substack here:
https://open.substack.com/pub/marketsentiment/p/the-devils-card-game
Just launched: WisdomTree Global Efficient Core UCITS ETF (NTSG USD/WGEC GBP on LSE): invests 90% in cap weighted diversified basket of global large cap equities with 60% exposure to global government bond futures overlaid on top, using the remaining 10% of the portfolio as cash collateral for the futures. The futures portfolio consists of US, German, UK and Japanese government bond futures contracts with maturities ranging from 2 to 30 years. Exposures are rebalanced quarterly.
Non daily reset / calendar (weekly or monthly reset) LETFs now available Stateside:
https://www.tradretfs.com/
Should help reduce the impact of the so called ‘Constant Leverage Trap’ / ‘Volatility Decay’ (a misnomer) / ‘Volatility Drag’ (my preferred term).
Perhaps the FCA’s PRIIPs Regulations’ review outcome will let investors buy this in the UK before too long.