ETF Complete Strategy Insights: The Ins and Outs of Leveraged ETFs (Part 3)

James Kimball | October 20, 2019

The ETF Complete model closed the week down -0.4% compared to the SPY which closed up 0.6%.

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This Week's Strategy Lesson: The Ins and Outs of Leveraged ETFs (Part 3)

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This week we are going to pick back up right where we left off last week talking about the different effects of leverage depending on how the market action during the trade plays out. Volatility and directionality each have unique effects.

In down trending markets, the leveraged compounding tends to reduce losses to lower than what you might expect with a simple multiple applied to the final return in the non-leveraged portfolio (though you still have to be careful about leveraged portfolios having exaggerated or critical drawdowns that can’t be weathered while the drawdown in the non-leveraged portfolio is quite reasonable).

In up trending markets, the leveraged daily compounding can dramatically increase our return over a simple multiple of the non-leveraged return value.

Let’s look at a few different scenarios.

Low Volatility and (Mostly) Flat Returns

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For this scenario, we look at the period of the performance of the SHY ETF and some simulated 3x and 5x returns. SHY corresponds to the 1-3 year treasuries and has extremely low volatility. Its 10-day average true range is currently around 6 cents on an $84 ETF.

Through the period above, SHY was down -0.2%. A simple 3x multiple would be -0.6%. The actual 3x daily leveraged return is -0.62%. A simple 5x multiple would be -1.0%. The actual 5x daily leveraged return is -1.08%. In this flat low volatility scenario, both leveraged instruments have decay, but it very small.

Higher Volatility and Negative Trending Market

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For this scenario, we look at the performance period in the JO ETF and some simulated 3x and 5x returns. JO is an ETF tracking the price of Coffee futures. During this period, JO was down about -16.5%. A simple 3x multiple would be down -50%. The actual 3x daily leverage return is -52%. A simple 5x multiple would be -83%. The actual 5x daily leveraged return is -78%.

Since stocks can’t go below zero, the leveraged instruments in a severely declining market will just get smaller and smaller as they approach zero. It should be noted that if any one day’s return was sufficiently negative, the leveraged instrument could go to zero. For instance, if the unleveraged baseline went down 20%, the 5x theoretically would go down 100% and hit zero.

While nowhere as extreme (because only 3x and a much shorter time period), we do have examples in our trading history where we lost more on a leveraged position than a simple 3x multiple.

In early 2015, the ETF Sector Conservative model entered TLT and six weeks later closed the trade out for a -2.24% loss. The ETF Sector Moderate entered the 3x leveraged TMF on the same dates and closed it out for a loss of -7.2%, slightly larger than the -6.7% that would have been expected from a simple 3x multiple.

Higher Volatility and Positive Trending Market

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For this scenario, we look at period in the SMH ETF and some simulated 3x and 5x returns. SMH is an ETF tracking the semiconductors industry. Semiconductors are essential parts of all computers, cell phones, and other electronic devices. This industry has been hot for a while and has posted strong recent gains.

During this period, SMH was up about +40%. A simple 3x multiple would be +120%. The actual 3x daily leveraged return is +160%. A simple 5x multiple would be +200%. The actual 5x daily leveraged return is +342%.

The difference is caused by the multiple periods of compounding. Here, in a strong uptrend, this compounding works dramatically in our favor. The 5x leveraged daily compounding resulted in a final gain that is 8.4x larger than the non-leveraged return.

This “extra” leverage through compounding multiple periods in a positive uptrend is not just theoretical. The ETF Sector Aggressive model had a stellar trade in the leveraged ETF SOXL that lasted almost two years.

Over that period, the unleveraged semiconductors ETF was up about 60%. A simple 3x multiple of that return would be around 180%, however, the 3x daily compounded semiconductor ETF was up 281% over that same period.

With the positive leveraged compounding, the 3x daily leveraged SOXL returned a 4.74x multiple return compared to the non-leveraged return of SMH over the same period.

The decay from volatile side-ways periods means you probably don’t want to arbitrarily “buy and hold” a leveraged ETF, though it is clear that the leverage and compounding works in your favor in a positively trending market. These are the type of markets and moves we are looking for and attempting to identify with the Trend Strength Indicator in the ETF models.

Next week we are going to wrap up this series reviewing how leveraged ETFs perform relative to the non-leveraged versions and cover some of the other factors that can cause divergences between the two.