Using a leveraged ETF as a long term investment?

[rmcelwee]

I am around three years out and doing a lot of thinking about money. Right now I have two buckets. One is a 401K which will be worth maybe $1.3M at retirement. The other is Roth, IRA, brokerage accounts worth around $500K at retirement. I will ultimately have a small pension, SS and some inheritance but I am not factoring these at the moment. We live very frugally with no debt and I do not believe this will change in the future.

If the $1.3M were to be invested in the fixed fund in my 401K we would see an annual return of $50K. Assuming that $50K a year is enough for us to live on what would be the problem with putting the other $500K in a leveraged ETF like UPRO (3X S&P). I think it would provide increased gains over the S&P in normal up years would fund large ticket items or withdraws to cash. In down years it would crash but that would be the time to use the dry powder accumulated during good years.

I'm trying to find a fault with this strategy and maybe the collective knowledge of this forum can help. I know the fees are huge (1%) but assuming an average return on the S&P they should be paid by gains. I also know that we have been in a bull market for a while so buying something like this at the top would not be as wise as buying it at the bottom but who knows when that will be. What am I missing?

 

[OldShooter]

I haven't thought about this kind of fund though in the Bad Old Days I did buy mutual funds on margin for a while. Nice zippy betas, for sure.

It's sort of the equivalent of borrowing at short-term rates and lending at long-term rates. Or maybe its a sort of rate arbitrage between the borrowings and the long-term future of the S&P.

I would want to know a lot about the borrowings and the risk of problems if the collateral falls in value by, say, 30%. This will probably happen. If they get the equivalent of a margin call, will they go to the shareholders to stump up the money? Probably not. They will sell their collateral aka your NAV as necessary. Then they won't have the shares when the market recovers, aka a sequence of returns risk.

Just thoughts. Personally I wouldn't touch something like this with a long stick.

 

[rmcelwee]

Just thoughts. Personally I wouldn't touch something like this with a long stick.

Thanks for the input. I have made some money with them over the past few years (have held some since the early 2000's) but it is a little scarier when I am thinking about retiring.

This is an example of one I first purchased around 2003. It is hard to find long term charts of these things. I don't know if it is because they come and go or if they are just now coming into style. That is why I am asking for comments.

 

[NW-Bound]

Leveraged ETFs only move 2x or 3x up or down as much as the indices that they track in the short term. In the long term they may not track that multiple.

For example, the above RYTNX was at 80 in 2000, but dropped below 10 in 2009. That's down to 1/8 of its high, while the S&P lost only 1/2 in the same time frame.

For short-term market timing, leveraged funds are great to use. You deploy $100K and get the gain (and also the loss) as if you bet $200K.

PS. I do use them when I want to increase my equity AA temporarily during a market drop, for a Tactical AA move. Hopefully, I will get a gain when the market recovers, then I get out. Of course, the market can move against you too. Major pain!

 

[ERD50]

You do realize a 33.3% dip would wipe that investment out?

You would be entering now, after a big run up in the market. I'm not into predictions, but I can't even come close to ruling out a 33% drop from here. Or, if we just bounce around up/down for 5 years, and you are down X% to fees, then a smaller drop would wipe you out.

If you were in a position of limited liquidity, say you had 4x as much tied up in fixed income you couldn't touch easily, then maybe using one of these makes sense to get to something like a 75/25 AA, using only 25% of total assets to purchase a 3x fund.

You did see the previous drops on that chart, right? Went from 58 to 34 end of 2018, when SPY had a modest dip of 292 to 240.

-ERD50

 

[LRDave]

Some folks like to gamble....

 

[NW-Bound]

In case someone misses it, what the OP is thinking about is a barbell strategy: keep a big chunk of the portfolio safe, then use the smaller portion in something with a higher risk and reward than the market. The idea is that they balance out somewhat.

If a person wants to put it all on leveraged ETFs or on options, that's something else entirely. The OP is not talking about that.

The barbell idea is not novel. People have been doing this in different ways, many involving options. I have contemplated this from time to time, but what is simple in concept is tougher to execute in real life. In the case of leveraged ETFs, the main problem is with mistracking in the long run.

 

[FI_RElater]

.....nope

there's been papers on holding leveraged funds...
the answer was- -don't do it, it's only good short term, the funds don't return 2X or 3X over a long period (especially over a year) and are virtually always high cost (with higher tax costs too)

see: https://www.bogleheads.org/wiki/Inverse_and_leveraged_ETFs

 

[ERD50]

In case someone misses it, what the OP is thinking about is a barbell strategy: keep a big chunk of the portfolio safe, then use the smaller portion in something with a higher risk and reward than the market. The idea is that they balance out somewhat.

The idea is not novel. People have been doing this in different ways, many involving options. I have contemplated this from time to time, but what is simple in concept is tougher to execute in real life.

If a person wants to put it all on leveraged ETFs or on options, that's something else entirely. The OP is not talking about that.

Yes, but he is talking about putting ~ 28% of his portfolio in a 3x fund.

Say the market drops 40%. If I have a 75/25 AA, overall I'm down 30% (to 70% of original), but assuming the market recovers, I recover too (we all remember 2008, right?).

But OP would be at 72% overall, but there would be no recovery, for him because his 28% was wiped out. It's gone.

-ERD50

 

[UnrealizedPotential]

My personal opinion is that even if you don't think you will need the 500K, it's way too large of a position to put in anything 3X. The downside in something like that is a killer. My feeling is if you want to do something like that, stick to 2X and limit yourself to no more than 10% of your total assets. 3X is playing with fire and in a bear market you will lose your behind.
I have to agree with ERD50 on this one. You could be potentially wiped out in a bear market and that 500K you thought you had to play with all of a sudden no longer exists. OP, you need to consider the downside as well as the upside.

 

[Animorph]

Morningstar was always pointing out that the way the ETF's defined their 3x it didn't work like you would think in the long term. One day was great, but investing for multiple days did not follow the annualized gains of the index. I think because the down days had a bigger effect than the up days.

Let's try an example.
The index goes down 10% then goes up 11% the next day. The 3x leveraged ETF should go down 30% and up 33%. The index ends at 0.9*1.11= 0.999 . The ETF ends at 0.7*1.33= 0.931 . So the index recovers to 99.9%. the ETF only gets to 93.1%. Every time the ETF goes down you're screwed.

Let's try another. The index goes up 10% then down 9.09%. The ETF goes up 30% then down 27.27%. The index is worth 1.1*0.909= 0.9999 The ETF is worth 1.3*0.7273 = 0.94549 . Again, the index recovered while the ETF lost about 5.5%.

 

[rmcelwee]

A good discussion with lots to think about. Thanks!

I just took a look at what UPRO did for 1Y vs S&P. UPRO was up 12.45% and S&P was up 7.06%. It was a pretty volatile period but I don't know if that proves or disproves anything. Not arguing, just providing a small amount of data during a period with some pretty good swings.


FWIW:
1Y 12.45% vs 7.06%
2Y 59.73% vs 22.15%
5Y 223.62% vs 56.85%

I can't go back further than this on the chart and I am not really sure it is a great representation of what UPRO actually did. No idea if fees and dividends are even calculated on this chart (I would bet that fees are not). Again, pretty big upswing during that past 5 years. Would like to see what it did during down years.

 

[njhowie]

If the $1.3M were to be invested in the fixed fund in my 401K we would see an annual return of $50K. Assuming that $50K a year is enough for us to live on what would be the problem with putting the other $500K in a leveraged ETF like UPRO (3X S&P). I think it would provide increased gains over the S&P in normal up years would fund large ticket items or withdraws to cash. In down years it would crash but that would be the time to use the dry powder accumulated during good years.

I'm trying to find a fault with this strategy and maybe the collective knowledge of this forum can help. I know the fees are huge (1%) but assuming an average return on the S&P they should be paid by gains. I also know that we have been in a bull market for a while so buying something like this at the top would not be as wise as buying it at the bottom but who knows when that will be. What am I missing?

The fault in the strategy is exactly what you're getting at in your last sentence, but haven't directly said it...what if the market crashes first, before you've accumulated dry powder? It could be several (or many) years before you are back in the black and have any dry powder to play with.

This is the sequence of returns risk, which many acknowledge, though there are a few around here who refuse to accept it.

 

[NW-Bound]

A good discussion with lots to think about. Thanks!

I just took a look at what UPRO did for 1Y vs S&P. UPRO was up 12.45% and S&P was up 7.06%. It was a pretty volatile period but I don't know if that proves or disproves anything. Not arguing, just providing a small amount of data during a period with some pretty good swings.


FWIW:
1Y 12.45% vs 7.06%
2Y 59.73% vs 22.15%
5Y 223.62% vs 56.85%

I can't go back further than this on the chart and I am not really sure it is a great representation of what UPRO actually did. No idea if fees and dividends are even calculated on this chart (I would bet that fees are not). Again, pretty big upswing during that past 5 years. Would like to see what it did during down years.

In a bull market, leveraged ETFs are great. When the market bounces sideways, they tend to dribble downward. Of course, when the market goes down, they crash hard. They are not good for long-term holding.

If you want to use them for short-term trading, they can be great if you have good timing. But then, with good timing you can make money trading anything.

 

[pumpkineater]

The fundamental problem with holding the leveraged etf's longer term, is that you also end up short volatility. In layman's terms that means every day the market goes down, the funds must sell stock to maintain the 3x leverage. Every day the market goes up, they are forced to buy more stock for the same reason. This daily trading pattern is the opposite of what investors try to do over the long term. So, you expect trading losses that are larger the more volatile the market turns out to be while the fund is held.

In recent years, equity volatility has been and stayed pretty low most of the time so these funds' longer term performance doesn't look so bad. But in a more normal environment for volatility, you risk considerable underperformance long term compared to just multiplying the index return by 3.

 

[pumpkineater]

Let me back up my statement with a time period when you can see what I mean:

During the nearly 3 year period from 11/5/2008 thru 9/30/2011, volatility averaged 27% as measured by the VIX.

During the same time, the Direxion Daily S&P 500 Bull (3x), returned 7.1% but the S&P 500 index itself returned 26.7%. So, because of high volatility, you would have been considerably better off without the leverage even though the market went up!

This was an extraordinary time period which I chose just to demonstrate the mechanics of how this works.

 

[rmcelwee]

This was an extraordinary time period which I chose just to demonstrate the mechanics of how this works.

I have not looked at it on a chart yet but this was exactly why I asked the question here. Thank you!

BTW, I don't look at many charts and would have a tough time finding data for custom time ranges like that. Where program/site are you using to see this?

 

[pumpkineater]

Glad to help. I have Bloomberg available here at work. It might also be do-able using other free tools available on the web.

 

[rmcelwee]

During the nearly 3 year period from 11/5/2008 thru 9/30/2011, volatility averaged 27% as measured by the VIX.

During the same time, the Direxion Daily S&P 500 Bull (3x), returned 7.1% but the S&P 500 index itself returned 26.7%.

Looking at 11/10/08 to 3/12/12 (pretty much the same time period you referenced but just 5 months longer):
SPXL went from 3.07 to 7.16 (a gain of 133%)
S&P went from 873 to 1404 (a gain of 61%)

Is the danger, in this extraordinary circumstance you mentioned, that I need to wait 5 months in order to pull some money @ more than DOUBLE the gains? You guys had me convinced until I looked at this. OR, am I looking at the chart incorrectly?

Using Yahoo finance here and it is hard to zoom in on it sometimes.

EDIT: I am playing around with Yahoo finance right now (learning how to use their charts better). Looking specifically at the high on 7/9/2007 before the market crash and how that affects RYTNX (2X S&P ETF). Looks like the recovery was pretty slow. Will give me some data to play around with. Thanks again!

 

[pumpkineater]

I think it only turned out that way, because the approximately 6 month period from 9/30/2011 - 3/12/12 saw a terrific equity rally of 22.4% even as volatility declined from 43% to 15.6%.

I'm not sure whether it's the average volatility or the decline in volatility that affects the results.

But I don't think you can count on the market emerging in a similar fashion next time. You might want to look at more time periods.

I think Morningstar did a write up on how levered etf's perform. I'll post the link if I come across it. Let us know what you decide if you care to share & good luck!

 

[pumpkineater]

https://www.morningstar.com/articles/271892/warning-leveraged-and-inverse-etfs-kill-portfolios

 

[6miths]

My recollection and reading on these funds was that stated by others. They are meant to be short term (hours/days) vehicles only and do not perform as expected in the longer term (weeks/months/years).

 

[GravitySucks]

Why not borrow enough money and buying twice as much of the underlying index and save the management fee?

 

[NW-Bound]

My recollection and reading on these funds was that stated by others. They are meant to be short term (hours/days) vehicles only and do not perform as expected in the longer term (weeks/months/years).

The leverage ratio of 2x and 3x can persist for longer periods in a bull market, meaning months or a year. That's why these leveraged funds can be quite seductive.

Just buy when the market goes up, and sell before it goes down, and you are all set.

Why not borrow enough money and buying twice as much of the underlying index and save the management fee?

You will have to pay the loan interest, and may face margin calls.

The dividend of the stocks bought with the loan will pay for the loan interest. And there is no risk of margin call in a bull market.

So, just don't do this when the market goes down. If it only goes up, you can do all sort of stuff to make money.