The Research Library of Newfound Research

Tag: levered etfs

Harvesting the Bond Risk Premium

This post is available as a PDF download here.

Summary­

  • The bond risk premium is the return that investors earn by investing in longer duration bonds.
  • While the most common way that investors can access this return stream is through investing in bond portfolios, bonds often significantly de-risk portfolios and scale back returns.
  • Investors who desire more equity-like risk can tap into the bond risk premium by overlaying bond exposure on top of equities.
  • Through the use of a leveraged ETP strategy, we construct a long-only bond risk premium factor and investigate its characteristics in terms of rebalance frequency and timing luck.
  • By balancing the costs of trading with the risk of equity overexposure, investors can incorporate the bond risk premium as a complementary factor exposure to equities without sacrificing return potential from scaling back the overall risk level unnecessarily.

The discussion surrounding factor investing generally pertains to either equity portfolios or bond portfolios in isolation. We can calculate value, momentum, carry, and quality factors for each asset class and invest in the securities that exhibit the best characteristics of each factor or a combination of factors.

There are also ways to use these factors to shift allocations between stocks and bonds (e.g. trend and standardizing based on historical levels). However, we do not typically discuss bonds as their own standalone factor.

The bond risk premium – or term premium – can be thought of as the premium investors earn from holding longer duration bonds as opposed to cash. In a sense, it is a measure of carry. Its theoretical basis is generally seen to be related to macroeconomic factors such as inflation and growth expectations.1

While timing the term premium using factors within bond duration buckets is definitely a possibility, this commentary will focus on the term premium in the context of an equity investor who wants long-term exposure to the factor.

The Term Premium as a Factor

For the term premium, we can take the usual approach and construct a self-financing long/short portfolio of 100% intermediate (7-10 year) U.S. Treasuries that borrows the entire portfolio value at the risk-free rate.

This factor, shown in bold in the chart below, has exhibited a much tamer return profile than common equity factors.

Source: CSI Analytics, AQR, and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

Source: CSI Analytics, AQR, and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

But over the entire time period, its returns have been higher than those of both the Size and Value factors. Its maximum drawdown has been less than 40% of that of the next best factor (Quality), and it is worth acknowledging that its volatility – which is generally correlated to drawdown for highly liquid assets with non-linear payoffs – has also been substantially lower.

The term premium also has exhibited very low correlation with the other equity factors.

Source: CSI Analytics, AQR, and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

A Little Free Lunch

Whether we are treating bonds as factor or not, they are generally the primary way investors seek to diversify equity portfolios.

The problem is that they are also a great way to reduce returns during most market environments through their inherently lower risk.

Anytime that an asset with lower volatility is added to a portfolio, the risk will be reduced. Unless the asset class also has a particularly high Sharpe ratio, maintaining the same level of return is virtually impossible even if risk-adjusted returns are improved.

In a 2016 paper2, Salient broke down this reduction in risk into two components: de-risking and the “free lunch” affect.

The reduction in risk form the free lunch effect is desirable, but the risk reduction from de-risking may or may not be desirable, depending on the investor’s target risk profile.

The following chart shows the volatility breakdown of a range of portfolios of the S&P 500 (IVV) and 7-10 Year U.S. Treasuries (IEF).

Source: CSI Analytics and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

Moving from an all equity portfolio to a 50/50 equity reduces the volatility from 14.2% to 7.4%. But only 150 bps of this reduction is from the free lunch effect that stems from the lower correlation between the two assets (-0.18). The remaining 530 bps of volatility reduction is simply due to lower risk.

In this case, annualized returns were dampened from 9.6% to 7.8%. While the Sharpe ratio climbed from 0.49 to 0.70, an investor seeking higher risk would not benefit without the use of leverage.

Despite the strong performance of the term premium factor, risk-seeking investors (e.g. those early in their careers) are generally reluctant to tap into this factor too much because of the de-risking effect.

How do investors who want to bear risk commensurate with equities tap into the bond risk premium without de-risking their portfolio?

One solution is using leveraged ETPs.

Long-Only Term Premium

By taking a 50/50 portfolio of the 2x Levered S&P 500 ETF (SSO) and the 2x Levered 7-10 Year U.S. Treasury ETF (UST), we can construct a portfolio that has 100% equity exposure and 100% of the term premium factor.3

But managing this portfolio takes some care.

Left alone to drift, the allocations can get very far away from their target 50/50, spanning the range from 85/15 to 25/75. Periodic rebalancing is a must.

Source: CSI Analytics and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

Of course, now the question is, “How frequently should we rebalance the portfolio?”

This boils down to a balancing act between performance and costs (e.g. ticket charges, tax impacts, operational burden, etc.).

On one hand, we would like to remain as close to the 50/50 allocation as possible to maintain the desired exposure to each asset class. However, this could require a prohibitive amount of trading.

From a performance standpoint, we see improved results with longer holding periods (take note of the y-axes in the following charts; they were scaled to highlight the differences).

Source: CSI Analytics and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

The returns do not show a definitive pattern based on rebalance frequency, but the volatility decreases with increasing time between rebalances. This seems like it would point to waiting longer between rebalances, which would be corroborated by a consideration of trading costs.

The issues with waiting longer between the rebalance are twofold:

  1. Waiting longer is essentially a momentum trade. The better performing asset class garners a larger allocation as time progresses. This can be a good thing – especially in hindsight with how well equities have done – but it allows the portfolio to become overexposed to factors that we are not necessarily intending to exploit.
  2. Longer rebalances are more exposed to timing luck. For example, a yearly rebalance may have done well from a performance perspective, but the short-term performance could vary by as much as 50,000 bps between the best performing rebalance month and the worst! The chart below shows the performance of each iteration relative to the median performance of the 12 different monthly rebalance strategies.

Source: CSI Analytics and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

As the chart also shows, tranching can help mitigate timing luck. Tranching also gives the returns of the strategies over the range of rebalance frequencies a more discernible pattern, with longer rebalance period strategies exhibiting slightly higher returns due to their higher average equity allocations.

Under the assumption that we can tranche any strategy that we choose, we can now compare only the tranched strategies at different rebalance frequencies to address our concern with taking bets on momentum.

Pausing for a minute, we should be clear that we do not actually know what the true factor construction should be; it is a moving target. We are more concerned with robustness than simply trying to achieve outperformance. So we will compare the strategies to the median performance of the previously monthly offset annual rebalance strategies.

The following charts shows the aggregate risk of short-term performance deviations from this benchmark.

The first one shows the aggregate deviations, both positive and negative, and the second focuses on only the downside deviation (i.e. performance that is worse than the median).4

Both charts support a choice of rebalance frequency somewhere in the range of 3-6 months.

Source: CSI Analytics and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

With the rebalance frequency set based on the construction of the factor, the last part is a consideration of costs.

Unfortunately, this is more situation-specific (e.g. what commissions does your platform charge for trades?).

From an asset manager point-of-view, where we can trade with costs proportional to the size of the trade, execute efficiently, and automate much of the operational burden, tranching is our preferred approach.

We also prefer this approach over simply rebalancing back to the static 50/50 allocation more frequently.

In our previous commentary on constructing value portfolios to mitigate timing luck, we described how tranching monthly is a different decision than rebalancing monthly and that tranching frequency and rebalance frequency are distinct decisions.

We see the same effect here where we plot the monthly tranched annually rebalanced strategy (blue line) and the strategy rebalanced back to 50/50 every month (orange line).

Source: CSI Analytics and Bloomberg. Calculations by Newfound Research. Data from 1/31/1992 to 6/28/2019. Results are hypothetical.  Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.  

Tranching wins out.

However, since the target for the term premium factor is a 50/50 static allocation, running a simple allocation filter to keep the portfolio weights within a certain tolerance can be a way to implement a more dynamic rebalancing model while reducing costs.

For example, rebalancing when the allocations for SSO and UST we outside a 5% band (i.e. the portfolio was beyond a 55/45 or 45/55) achieved better performance metrics than the monthly rebalanced version with an average of only 3 rebalances per year.

Conclusion

The bond term premium does not have to be reserved for risk-averse investors. Investors desiring portfolios tilted heavily toward equities can also tap into this diversifying return stream as a factor within their portfolio.

Utilizing leveraged ETPs is one way to maintaining exposure to equities while capturing a significant portion of the bond risk premium. However, it requires more oversight than investing in other factors such as value, momentum, and quality, which are typically packaged in easy-to-access ETFs.

If a fixed frequency rebalance approach is used, tranching is an effective way to reduce timing risk, especially when markets are volatile. Aside from tranching, we find that, historically, holding periods between 3 and 6 months yield results close in line with the median rolling short-term performance of the individual strategies. Implementing a methodology like this can reduce the risk of poor luck in choosing the rebalance frequency or starting the strategy at an unfortunate time.

If frequent rebalances – like those seen with tranching – are infeasible, a dynamic schedule based on a drift in allocations is also a possibility.

Leveraged ETPs are often seen as risk trading instruments that are not fit for retail investors who are more focused on buy-and-hold systems. However, given the right risk management, these investment vehicles can be a way for investors to access the bond term premium, getting a larger free lunch, and avoiding undesired de-risking along the way.

Levered ETFs for the Long Run?

This blog post is available as a PDF download here.

Summary­­

  • We believe that capital efficiency should remain a paramount objective for investors.
  • The prudent use of leverage can help investors employ more risk efficient portfolios without necessarily sacrificing potential returns.
  • Many investors, however, do not have access to leverage (be it via borrowing or derivatives). They may, however, have access to leverage via Levered ETFs.
  • Levered ETFs are often dismissed as trading vehicles, not suited for buy-and-hold investors due to the so-called “volatility drag.” We show that the volatility drag is a component of all compounding returns, whether they are levered or not.
  • We explore the impact that the reset period can have on Levered ETFs and demonstrate how these ETFs may be used in the context of a portfolio to introduce diversifying, alternative exposures.

Early last month, we published a piece titled Portable Beta: Making the Most of the Returns You’re Already Getting, in which we outlined an argument whereby investors should focus on capital efficiency.  We laid out four ways in which we believe that investors can achieve greater efficiency:

  1. Reduce fees to take home more of what you earn.
  2. Express active views more purely so that we are not caught paying active management prices for closet beta.
  3. Focus on risk management by “diversifying your diversifiers” with strategies like trend following that can help increase exposure to higher return asset classes without necessarily increasing the overall portfolio risk profile.
  4. Utilize modest leverage so that investors can create more risk-efficient portfolios without necessarily sacrificing potential return.

Unfortunately, for many investors, access to true leverage – either through borrowing or the use of derivatives – may be beyond their means.  Fortunately, there are a number of ETFs available today that allow investors to access leverage in a packaged manner.

Wait, Aren’t Levered ETFs Dangerous?

Levered ETFs have quite a reputation, and not a good one at that.  A quick search will result in numerous articles that tell you why they are a dangerous, bad idea.  They are pejoratively dismissed as “trading vehicles,” unsuitable for “buy and hold.”

Most often, the negative publicity hinges on the concept of volatility decay (or, sometimes “volatility drag”).  To illuminate this concept, let’s assume there is a stock that can only go up either +X% or down –X%.  Thus, in any two-day period, we have the following growth in our wealth:

UpDown
Up(1 + X%)(1 + X%)(1 – X%)(1 + X%)
Down(1 + X%)(1 – X%)(1 – X%)(1 – X%)

 

If we expand out the returns, we are left with:

UpDown
Up1 + 2X% + X%21 – X%2
Down1 – X%21 – 2X% + X%2

 

Note that in the case where the stock went up +X% and then down -X% (or down –X% and then up +X%), we did not end up back at our starting wealth.  Rather, we ended up with a loss of -X%2.

On the other hand, we can see that when the stock goes the same direction, we actually outperform twice the daily return by +X%2.

What’s going on here?

It is nothing more than the math of compound returns.  The returns of the second day compound the returns of the first.

The effect earns the moniker volatility decay because in return environments that are mean-reversionary (e.g. positive returns follow negative returns, and vice versa), our capital decays due to the -X%2 term.

Note, however, that we haven’t even introduced leverage into the scenario yet.  This drag is not unique to levered ETFs: it is just the math of compounding returns.  Why it gets brought up so frequently with respect to levered ETFs is because the leverage can accentuate it.  Consider what happens if we introduce a daily leverage factor of L:

UpDown
Up1 + 2LX% + L2X%21 – L2X%2
Down1 – L2X%21 – 2LX% + L2X%2

 

When L=1, we have a standard long-only investment.  When L=2, we have our 2X daily levered ETFs.  What we see is that when L=1, our drag is simply –X%2.  When L=2, however, our drag is 4X%2.  When L=3, the drag skyrockets to 9X%2.  Of course, the so-called drag turns into a benefit in trending markets (whether positive or negative).

So why do we not see this same effect when we use traditional leverage?  After all, are these ETFs not using leverage under the hood to achieve their returns?

The answer lies in the daily reset.  Note that these ETFs aim to give you a multiple of returns every day.  The same is not true if we simply lever our notional exposure and never reset it.  By “reset,” we mean pay back what we owe and re-borrow capital in order to maintain our leverage ratio.

To achieve 2X daily returns, the levered ETFs basically borrow their NAV, invest in the asset class, and then pay back what they borrowed.  Hence, every day they reset how much they borrow.

If we never reset, however, the proportion of our capital that is levered varies over time.  Consider, for example, investing $10,000 of our own capital in the SPDR S&P 500 ETF and borrowing another $10,000 to invest alongside (for convenience, we’re going to assume zero borrowing cost).  As the market has gone up over time, the initial $10,000 borrowed becomes a smaller and smaller proportion of our capital.

Source: CSI.  Calculations by Newfound Research.  Assumes portfolio applies 100% notional leverage applied to SPDR S&P 500 ETF (“SPY”) at inception of ETF.  Assumes zero cost of leverage. 

This happens because while we owe the initial $10,000 back, the returns made on that $10,000 are ours to keep.  In the beginning, our portfolio will behave very much like a 2X daily levered ETF.  As the market trends upward over time, however, we not only compound our own capital, but compound our gains on the levered capital.  This causes our actual leverage to decline over time.  As a result, our daily returns will gradually converge towards that of the market.

In practice, of course, there would be a cost associated with borrowing the $10,000.  However, the same fact pattern applies so long as the growth of the portfolio exceeds the cost of leverage.

Resetting, therefore, is a necessary component of maintaining leverage.  On the one hand, we have daily resets, which keeps our leverage proportion constant.  On the other hand, we have “never reset,” which will decay the leverage proportion over time (assuming the portfolio grows faster than the cost of leverage).  There are, of course, shades of gray as well.  Consider a 1-year reset:

Source: CSI.  Calculations by Newfound Research.  Assumes portfolio applies 100% notional leverage applied to SPDR S&P 500 ETF (“SPY”) at inception of ETF and reset every 252-days thereafter.  Assumes zero cost of leverage. 

Note that in 2008, the debt proportion of our balance sheet spiked up to nearly 90% of our capital.  What happened?  This is reset timing risk.  On 4/2008, the portfolio reset, borrowing $92,574 against our equity of $92,574.  Over the next year, the market fell approximately 39%.  Our total assets tumbled from $185,148 to $114,753 and we still owed the initial $92,574 we borrowed.  Thus, our actual equity over this period fell an astounding -76.7%.

(It is worth pointing out that if we had considered a “never reset” portfolio that started on 4/2008, we’d have the same result.)

Frequent readers of our commentary may be wondering, “can this reset timing risk be controlled with overlapping portfolios just like other timing risks?”  Yes … ish.  On the one hand, there is not a whole lot we can do about the drawdown itself: 100% notional leverage plus a 37% drawdown means you’re going to have a bad time.  Where overlapping portfolios can help is in ensuring that resets do not necessarily occur at the worst possible point (e.g. the bottom of the drawdown) and lock in losses.

As a general rule, we probably don’t want to apply N-times exposure over a time frame an asset class can experience a return of -1/N%.  For example, if we want 2x equity exposure, we want to make sure we reset our leverage exposure well before equities have a chance to lose 50% (1/2).  Similarly, if we want 3x exposure, we need to reset well before we can lose 33.3% (1/3).

So, Are They Evil or What?

We would argue that volatility decay takes the blame when it is not actually the culprit.  Volatility decay is nothing more than the math of compounding returns: it happens whether you are levered or not.

The danger of most levered ETFs is more easily explained.  If I told you I was going to take your investment, use it as collateral to gain 100% notional exposure to equities, and then invest that collateral in equities as well – an asset class than can easily lose 50% –what would you say?  When put that way, it sounds a little nuts.  It really isn’t much more complicated than that.

The reset effect really just introduces a few more nuanced wrinkles.  The more frequently we reset, the less risk we run of going bust, as we take risk off the table as our debt-to-equity ratio climbs.  That’s how we can avoid complete ruin with 100% leverage in an asset class that falls more than 50%.

On the other hand, the more frequently we reset, the closer we keep the portfolio to the target volatility level, increasing the drag from short-term mean reversion.

We’ve said it before and we’ll say it again: risk cannot be destroyed, only transformed.

But, these things might have their use yet…

Levered ETFs in a Portfolio

Held as 100% of our wealth, a 2X daily reset equity ETF may not be too prudent.  In the context of a portfolio, however, things change.

Consider, for example, using 50% of our capital to invest in a 2x equity exposure and the remaining 50% to invest in bonds.  In effect, we have created 150% exposure to a 67/33 stock/bond mixture.  For example, we could hold 50% of our capital in the ProShares Ultra S&P 500 ETF (“SSO”) and 50% in the iShares Core U.S. Bond ETF (“AGG”).

To understand the portfolio exposure, we have to look under the hood.  What we really have, in aggregate, is: 100% equity exposure and 50% bond exposure.  To get to 150% total notional exposure, we have to borrow an amount equal to 50% of our starting capital.  Indeed, at the portfolio level, we cannot differentiate whether we are using that 50% borrowing to lever up stocks, bonds, or the entire mixture!

In this context, levered ETFs become a lot more interesting.

The risk, of course, is in the resets.  To really do this, we’d have to rebalance our portfolio back to a 50/50 mix of the 2x levered equity exposure and bonds on a daily basis.  If we could achieve that, we’d have built a daily reset 1.5x 66/33 portfolio.

More realistically, investors may be able to rebalance their portfolio quarterly.  How far does that deviate from the daily rebalance?  We plot the two below.

Source: CSI.  Calculations by Newfound Research.  Returns for the Daily Rebalance and Quarterly Rebalance portfolios are backtested and hypothetical.  Returns are gross of all fees except underlying ETF expense ratios.  Returns assume the reinvestment of all distributions.  Cost of leverage is assumed to be equal to the return of a 1-3 Year U.S. Treasury ETF (“SHY”).  Past performance is not indicative of future results.  The Daily Rebalance portfolio assumes 50% exposure to a hypothetical index providing 2x daily exposure of the SPDR S&P 500 ETF (“SPY”) and 50% exposure to the iShares US Core Bond ETF (“AGG”) and is rebalanced daily.  The Quarterly Rebalance portfolio assumes the same exposure, but rebalances quarterly.

Indeed, for aggressive investors, a levered equity ETF mixed with bond exposure may not be such a bad idea after all.  However – and to steal a line from our friends at Toroso Asset Management – levered ETFs are likely “buy-and-adjust” vehicles, not buy-and-hold.  The frequency of adjusting, and the cost of doing so, will play an important role in results.

A Particular Application with Alternatives

Where levered ETFs may be particularly interesting is in the context of liquid alternatives.

In the past, we have said that many liquid alternatives, especially those offered as ETFs, have a volatility problem.  Namely, they just don’t have enough volatility to be interesting.

Traditionally, allocating to a liquid alternative requires us removing capital from one investment to “make room” in our portfolio, which creates an implicit hurdle rate.  If, for example, we sell a 5% allocation of our equity portfolio to make room for a merger arbitrage strategy, not only do we have to expect that the strategy can create alpha beyond its fees, but it also has to be able to deliver a long-term return that is at least in the same neighborhood of the equity risk premium.  Otherwise, we should be prepared to sacrifice return for the benefit of diversification.

One solution to this problem with lower volatility alternatives is to fund their allocation by selling bonds instead of stocks.  Bonds, however, are often our stable ballast in the portfolio.  Regardless of how poorly we expect core fixed income to perform over the next decade, we have a high degree of certainty in their return.  Asking us to sell bonds to buy alternatives is often asking us to throw certainty out the window.

By way of example, consider the Reality Shares DIVS ETF (“DIVY”).  We wrote about this ETF back in August 2016 and think it is a particularly compelling story.  The ETF buys the floating leg of dividend swaps, which in theory captures a premium from investors who want to insure their dividend growth exposure in the S&P 500.

For example, if the swap is priced such that the expected growth rate of S&P 500 dividends is 5% over the next year, but the realized growth is 6%, then the floating leg keeps the extra 1%.  The “insurance” aspect comes in during years where realized growth is below the expected rate, and the floating leg has to cover the difference.  To provide this insurance, the floating leg demands a premium.

A dividend swap of infinite length should, in theory, converge to the equity risk premium.  Short-term dividend swaps (e.g. 1-year), however, seem to exhibit a potentially unique risk premium, making them an interesting diversifier within a portfolio.

While DIVY has performed well since inception, finding a place for it in a portfolio can be difficult.  With low volatility, we have two problems.  First, for the fund to make a meaningful difference, we need to make sure that our allocation is large enough.  Second, we likely have to slot DIVY in for a low volatility asset – like core fixed income – so that we make sure that we are not creating an unreasonable hurdle rate for the fund.

Levered ETFs may allow us to have our cake and eat it too.

For example, ProShares offers an Ultra 7-10 Year Treasury ETF (“UST”), which provides investors with 2x daily return exposure to a 7-10 year U.S. Treasury portfolio.  For investors who hold a large portfolio of intermediate-term U.S. Treasuries, they could potentially sell some exposure and replace it with 50% UST and 50% DIVY.

As before, the question of “when to reset” arises: but even with a quarterly [rebalance, we think it is a compelling concept.

Source: CSI.  Calculations by Newfound Research.  Returns for the S&P 500 Dividend Swaps Index and 50% 2x Daily 7-10 Year US Treasuries / 50% Dividend Swap Index portfolios are hypothetical and backtested.  Returns are gross of all fees except underlying ETF expense ratios.  Returns assume the reinvestment of all distributions.  Cost of leverage is assumed to be equal to the return of a 1-3 Year U.S. Treasury ETF (“SHY”).  Past performance is not indicative of future results.  The 50% 2x Daily 7-10 Year US Treasuries / 50% Dividend Swap Index assumes a quarterly rebalance.

Conclusion

Leverage is a tool.  When used prudently, it can help investors potentially achieve much more risk-efficient returns.  When used without care, it can lead to complete ruin.

For many investors who do not have access to traditional means of leverage, levered ETFs represent one potential opportunity.  While branded as a “trading vehicle” instead of a buy-and-hold exposure, we believe that if prudently monitored, levered ETFs can be used to help free up capital within a portfolio to introduce diversifying exposures.

Beyond the leverage itself, the daily reset process can introduce risk.  While it helps maintain the leverage ratio ­– reducing risk after losses – it also re-ups our risk after gains and generally will increase long-term volatility drag from mean reversion.

This daily reset means that when used in a portfolio context, we should, ideally, be resetting our entire portfolio daily.  In practice, this is impossible (and likely imprudent, once costs are introduced) for many investors.  Thus, we introduce some tracking error within the portfolio.

We should note that there are monthly-reset leverage products that may partially alleviate this problem.  For example, PowerShares and ETRACS offer monthly reset products and iPath offers “no reset” leverage ETNs that simply apply a leverage level at inception and never reset until the ETN matures.

Perhaps the most glaring absence in this commentary has been a discussion of fees.  Levered ETP fees vary wildly, ranging from as low as 0.35% to as high as 0.95%.  When considering using a levered ETP in a portfolio context, this fee must be added to our hurdle rate.  For example, if our choice is between just holding the iShares 7-10 Year U.S. Treasury ETF (“IEF”) at 0.15%, or 50% in the ProShares Ultra 7-10 Year Treasury ETF (“UST”) and 50% in the Reality Shares DIVS ETF (“DIVY”) for a combined cost of 0.93%, the extra 0.78% fee needs to be added to our hurdle rate calculation.

Nevertheless, as fee compression marches on, we would expect fees in levered ETFs to come down over time as well, potentially making these products interesting for more than just expressing short-term trading views.

 

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