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Leverage is probably one of the most controversial subjects in investing. Used properly (and given a bit of good fortune), the benefits of leverage can be amazing. Leverage is the reason why home ownership is often viewed as one of the best ways of building wealth. 2008 notwithstanding, real estate prices have historically risen reliably over time. It’s also one of the few areas in which John Q Public routinely invests (or has access to) 5x or greater leverage. On the other hand, Wall Street is littered with defunct hedge funds that over levered and went bust in fantastic fashion.
Traditionally there were a couple of ways to lever up an investment. The simplest is using margin – borrowing to increase your purchasing power. Then of course there are derivatives, e.g. futures and options. Although accessible by (some) retail investors, these tools were largely the domain of institutions. In addition to their inaccessibility, each of these mechanisms for gaining leverage have elements that make them intimidating. Margin and futures come with the possibility of margin calls, and options can quickly become worthless if the investor isn’t correct about timing, direction, and magnitude.
Leveraged ETFs, a relatively recent entrant into the market, with the first fund being introduced in 2006, brought retail investors easy access to leverage that does not subject them to margin calls or simply expire worthless like an option. Another innovation made possible by ETFs, which goes hand-in-hand with leveraged funds, are inverse strategies. By providing them with a means to gain short exposure to various assets without having to take derivatives positions or short the stocks themselves inverse strategies, like leveraged funds, gave retail investors access to another area that had largely been dominated by institutions. And of course, these two concepts have been combined into the leveraged short strategies.
Leveraged and inverse funds have several advantages, they’re readily accessible, aren’t subject to margin calls, and don’t require a detailed understanding of derivatives. However, they do have some disadvantages, the biggest of which is performance decay caused by volatility which can result in performance numbers which are very different from what you would expect. The recent up-and-down market we have experienced illustrates just how pronounced this decay can be. Year-to-date (through 5/6/2020) the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100 has returned 3.01%. However, the ProShares UltraPro QQQ 3x ETF (TQQQ), which aims to provide 3x the daily return of the same index, is down -20.06% over the same period. Quite different from what you might expect!
The returns above are price returns, not inclusive of dividends or all transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
So, why is there is such a large difference? While there are multiple possible sources of tracking error or performance decay like expense ratio or roll yield (positive or negative) from the use of futures contracts, in the case of inverse and leveraged funds, by far the single largest factor is compounding of returns.
The quote below is from the ProShares UltraPro S&P 500 (SSO) website:
Due to the compounding of daily returns, holding periods of greater than one day can result in returns that are significantly different than the target return and ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks.
Like SSO, the vast majority of leveraged funds on the market today have a daily reset, i.e. their objective is to return a multiple (usually 2x or 3x) of the daily return of a benchmark like the S&P 500. The daily reset of leverage means that its effects are compounded daily.
In order to see how this daily compounding results in decay, let’s take a look at a set of hypothetical S&P 500 returns over a five-day period.
Day 1: -10%, Day 2: +5%, Day 3: -5%, Day 4: +15%, Day 5: -5%. This gives us a compounded return of -1.92%; multiplying by two gives us -3.84%. However, over the same period a 2x leveraged fund would have daily returns Day 1: -20%, Day 2: +10%, Day 3: -10%, Day 4: +30%, Day 5: -10%, which gives us a compounded return of -7.34%. The effects of compounding have resulted in an actual return that is 3.5% lower than two times the S&P 500’s return.
The daily reset of these funds does have its advantages. In the case of funds whose target is a large cap US equity index like SPX or the Nasdaq 100, the circuit breakers in the US equity market reduce the likelihood that one of these funds can go to zero. Because trading is halted for the day if the S&P 500 loses 20% of its value, a 2x fund tracking the S&P 500, like SSO, can reasonably be expected to have a maximum single day drawdown of around 40% or 60% in the case of a 3x fund. And of course, you can hypothetically lose 40% every day without every reaching zero (this shouldn’t be interpreted to mean that one of these funds could never go to zero.)
This, of course would not be the case over longer time periods, over a one-month period, for example, SPX could hypothetically lose 50% of its value and a 2x levered fund would go to zero. Nor is this the case for levered funds tracking other indexes or assets. Just last month we saw the front month contract for WTI crude oil lose more than 100% of its value in one day, which would not only be enough to wipe out levered funds but also potentially unlevered funds as well. And unsurprisingly, there were leveraged oil ETPs that were shuttered shortly thereafter.
The effects of compounding can also be advantageous in a trending market – i.e. one in which the market moves in the same direction each day. However, negative numbers have an outsized impact on compound returns – an investment that loses 50% must gain 100% to get back at its starting value – and as a result, over an extended holding period, the odds favor that the net effect of compounding leverage daily will be to deteriorate, not enhance, performance.
At this point you may be thinking “OK, I understand why levered funds have performance decay. But, why would a 1x inverse fund?” While it may not be quite as intuitive, the answer is essentially the same – because the short exposure resets daily – which is different than if you were to sell short shares of a stock. If you short XYZ stock at $100 and it does down $10, XYZ is now worth $90 and you’ve made $10 and 10%. If XYZ is up 10% the next day it would be worth $99 and you would still be $1 or 1% in the black because you sold it for $100.
Now, if you invested the same $100 in ZYX inverse fund and on day one its target went down by 10%, your investment would now be worth $110 and you would have gained $10 or 10%. But, before day two, your short exposure would reset. So, on day two when XYZ gains 10%, the value of XYZ inverse fund also decreases by 10%, but, your starting value for the day was $110 meaning that your return for the day is -$11, bringing your two-day return to -$1 or -1%.
As you might expect, the deterioration is more pronounced when you add the effects of leverage to an inverse fund as the image below illustrates.
The intent of this article is not to lead you to conclude that leveraged or inverse ETFs are bad products or that you should avoid them completely. Used correctly they can be a wonderful tool that can help enhance your returns and gain exposure in ways that otherwise may have been impractical or impossible. However, as we’ve illustrated, the actual performance of these funds can differ drastically from what someone who is unfamiliar with them might expect. We hope that after this discussion you have a better understanding of the inner workings of these products and that it will aid you should you need to field any questions about them from clients or prospects.
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Dorsey, Wright & Associates, LLC, a Nasdaq Company, is a registered investment advisory firm. Registration does not imply any level of skill or training.
The Dorsey Wright Sector Indexes are non-investable, equal weighted baskets of stocks including the largest and most liquid names from within each sector. The indexes are rebalanced daily and do not include the reinvestment of dividends. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
Unless otherwise stated, the performance information included in this article does not include dividends or all potential transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
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