Thursday, December 10, 2015

Defending Leverage

I just learned today that the SEC will make an announcement tomorrow on 12/11/15 regarding derivatives and how ETF providers use them to create levered products.  What follows is my opinion on the topic.

I think that everyone understands by now how leverage can be used irresponsibly as there are dozens of books and articles that attempt to demonize the entire industry of leveraged products.  I think that it is important as a successful saver and investor to speak up about how I use these products responsibly to actually reduce my risk profile.

I don't think leverage or inverse leverage is the real problem but rather the people that misuse these products that are to blame.  These people are the same people that buy a house with a less than 10% down payment (leverage) or put a new car on their credit card (leverage) or buy stocks on margin (leverage).  Basically, these people will find a way to be irresponsible with their money regardless of what regulations exist.

The biggest source of controversy with levered products seems to be the "decay" factor due to daily rebalancing which is no dark secret but rather a basic mathematical fact regarding the nature of percentages.  I rarely see it discussed, but this same "decay" factor that degrades performance in range bound markets can actually enhance performance in trending up a spreadsheet and try it out for's basic math!

Finally, the responsible way to use leverage is to hedge investments rather than to amplify them.  For instance, if the market takes a sudden sharp downturn because of some random geopolitical issue and I have extra cash to invest because I am a prudent saver; I can use a levered product in this situation to actually reduce my risk. 

Instead of going out into the market and buying $10K worth of the S&P 500 index I can instead buy $5K worth of its equivalent 2X levered product and if we go into a sudden recession or depression I am only out the $5K instead of the full $10K.  Whatever "decay" I may end up paying for is just the cost of the protection that allows me to keep half of my money if everything ends up going to zero.  Do not delude this era of flash crashes your nice and safe vanilla index fund can just as easily go to zero for some bizarre off the wall reason as can these "highly dangerous" leveraged products.  Always remember, investments don't lose money...people lose money.

Is there a case for buying and holding leveraged ETFs?

No doubt that this statement will be offensive to many journalists and investors alike who are 100% convinced that leveraged ETFs are horrible investments due to their seemingly unpredictable nature.  I think it is more of a situation that they are just not very well understood and just like many things that people don't understand the immediate reaction is almost always negative.

Here is where the misunderstanding comes from.  Embedded within an investment in a leveraged fund is an investment in volatility or rather inverse volatility.  Now since many writers and investors do not have very much experience with options they see volatility as a mystery or rather something to be feared.  I  can assure you that among the option investing community buying or selling levels of volatility is just as normal and regular as buying shares of Apple or Facebook.  What you get with your leveraged investment is an exposure that will perform better in an environment where volatility is falling and perform worse in an environment where volatility is rising.  So when choosing these investments it is important to have a general opinion regarding future market volatility.

So why would anyone want to buy and hold these investments for the long term?  The reason is simple...the market tends to rise over long periods of time (decades) and volatility tends to fall over time due to the price discovery mechanism built into all free markets.  If you believe that this statement is true then a leveraged investment should outperform a similar unleveraged investment over longer periods of time.

If you are still confused then think of it this way.  If I transported myself back to the 1950's using Doc Brown's time machine and took with me $20 dollars to invest for the next sixty years in a leveraged investment or an unleveraged investment why would I not pick the leveraged investment?  In both scenarios I can only lose $20 but with leverage you have the potential for so much more return so long as the market rises over the next sixty years with less volatility.  How much more return can I expect?  Well I ran a simulation on the S&P 500 index and your $20 invested in a 3X leveraged fund back in the 1950's would be worth almost $200,000 dollars today while that same $20 invested in a plain unleveraged fund would be worth just over $1,900.  Huge difference, it much larger than you expected?  This is because you are not just getting leveraged returns but you are also getting leveraged compounding. 

So if you are now amazed and convinced let me pull you back in a little bit and caveat this investment strategy with several important warnings.  I would not be investing the majority of my wealth in a leveraged investment.  This investment has such huge upside potential that a very small investment would be more than enough to add diversity to your portfolio.  Also there is no 100% guarantee that the market will rise over the next sixty years or even the next one hundred years with lesser volatility.  The other issue is that currently, leveraged funds have significantly higher fees than similar unleveraged funds.  When accounting for higher fees your return is more than cut in half.  Finally, using the S&P 500 in this case worked because it has a long history of providing long term stable returns but running this simulation on more volatile markets like the Nasdaq 100 or the Russell 2000 provided for less convincing results.  Whatever you decide, use your own judgment, don't over do it, be long term and stay diversified.