How to Beat the Market with "Intelligent" Leverage

Reinventing the wheel, building a better mousetrap, squaring the circle? Pick your cliché, because it could be happening today.

I have become a more vociferous, perhaps even obnoxious, proponent of the newfangled leveraged ETFs, which, as I have familiarized myself with the investments, I find are not so new.

ProShares introduced the world to leveraged ETFs 18 years ago. Direxion played monkey-see, monkey-do three years later. The offerings have expanded considerably since the introduction. From broad-market ETFs leveraged 2X and then 3X that have enabled retail investors to leverage their bullish or bearish hunches on the macro-equity backdrop, to 2X and 3X leveraged sector, themed, commodity, precious metal, bond, cryptocurrency, and, more recently, individual stock ETFs that enable investors to leverage their hunch on a more atomized scale.

I’ll concede that I initially gave leveraged ETFs the cold shoulder, as did most in the CFA charter-holding fraternity. The objections are well vetted: high annual fees, typically between 90 and 110 basis points; volatility decay, which erodes value in static and downward trending markets; volatility decay amplified by leverage; and daily settling that leads to tracking error over time, which means the leveraged ETF fails to track its unleveraged index precisely 2X or 3X.

Moreover, the relationship has been positioned as short-term. Forget until death do us part. The relationship is more akin to the cheap motel “quickie” – check in and check out before the trading day ends with no love lost and hopefully a profit gained.

I will agree in most instances, but not all. My interest in leveraged ETF interest was piqued after the broad-based market sell-off that occurred immediately following the initial spasms of Covid-induced hysteria. I offer a “for instance.”

The iShares Semiconductor ETF (SOXX) suffered a 34% max. drawdown the month following the Covid onset. Its 3X leveraged tracking ETF, the Direxion Daily Semiconductor Bull 3X ETF (SOXL), suffered an 80% max. drawdown, not quite 3X, but close enough.

And this is where these leveraged ETFs get interesting.

After the dust appeared to settle two months after the Covid-panic (excuse me, pandemic) and the accompanying equity-market hard-sell, the deeply discounted leveraged SOXL ETF offered an intriguing value proposition.

If you are presented with a leveraged opportunity on a sector we are convinced has a future – and I’ll assume we’re all convinced the semiconductor sector has a future – we might consider the opportunity.

We’re given to chatting up our contrarian bona fides when opportunities are nonexistent and our risk tolerance has been anesthetized by the extended bull-market run but talk generates a zero return. Money on a 3X leveraged ETF investment that had just suffered an 80% max drawdown during a flash bear market, I think that could pay off. The SOXL ETF was the opportunity.

Of course, we’re considering everything in arrears, which simplifies life because we all know the outcome. The SOXX ETF was down 34%, the SOXL ETF was down nearly treble its tracking index percentage. A year later, the SOXX had posted a 90% CAGR; the SOXL, a 400% CAGAR, more than treble that of the SOXX. What’s more, the SOXL CAGR was generated with buy and hold. This wasn’t a matter of daily settlement for the investor – buying and selling daily over the 52 weeks. This was buying and holding for 52 weeks. A daily settlement leveraged ETF can be more than a day-trading plaything if the price is right.

The above scenario is cherry-picked, but I have found the contrarian strategy can work. I have bought deeply discounted leveraged sector ETFs and held them for over a year. It hasn’t been perfect – perfection being of another world – but additions have exceeded the subtractions. That said, I view these leveraged sector ETF contra-bets as a side hustle, a diversion, entertainment even. (Don’t downplay an investor’s desire to be entertained. Many, you might be surprised, value entertainment first.) These leveraged sector ETFs are bought to be sold, so for that reason I view them as something less than an investment.

As for a more permanent footing, I have carved out a portion of my investment portfolio — albeit small, around 5% — to leveraged broad-market ETFs predicated on the classic 60/40 portfolio. That is, a portfolio composed of a leveraged S&P 500 ETF for the 60% allocation and the remaining 40% to leveraged long-dated (20%) and intermediate-dated (20%) U.S. Treasurys ETFs. I rebalance quarterly to the 60/40 percentages. I contribute annually.

(Sidebar: I also have a smaller carve-out portfolio that modifies the classic 60/40 to include an allocation to a contra-leveraged S&P 500 ETF to tamp down the volatility a bit. All of it is housed in retirement accounts – traditional and Roth IRAs. Given the turnover with the leveraged ETF and the rebalancing, retirement accounts provide the best wrapping for executing the strategy.)

The leveraged portfolio is a worthwhile option for an investor with a long runway whose dollar-cost averaging. The graph below compares the S&P 500 to an unleveraged classic 60/40 portfolio and leveraged iterations thereof with a buy-and-old strategy and quarterly rebalancing. I have assumed $200 to start and $200 contributed monthly thereafter.

Let’s ugly things up a bit for transparency’s sake. Let’s assume our long runwayed, DCAing investor started his journey in January 2020. This means he would have had to endure the pandemic-induced flash sell-off that occurred in March 2020 and the dual stock and bond bear markets that occurred in 2022. How’s he doing?

OK, but he could have done better 2020 to date. The dual bear markets in 2022 neutered the favorable risk characteristics of the classic 60/40 portfolio. The S&P 500 portfolio has held sway over the past four years because of the bond bear market. The classic 60/40 continues to be hindered to this day by bond volatility unseen in decades. Leverage, as you would expect, exacerbates the issue.

Still, we are talking about a long runway. The 2X leveraged classic 60/40 portfolio, rebalanced quarterly, has generated three percentage points more CAGR over the past 14 years than the S&P 500 with a similar, if not a more efficient, risk profile as measured by daily volatility, the Sharpe and Sortino ratios, and beta. And if you could stomach the higher max. drawdown (which investors frequently underestimate), you would have picked up an additional 10 percentage points of CAGR with the 3X variant.

(Sidebar: Pickings in the leveraged EFT world were slim before the Great Financial Meltdown of 2008. The ProShares Ultra S&P 500, a 2X S&P 500 leveraged ETF, was one of the few that predates the crisis. The ProShares ETF hit the public airways in June 2006. If our long runwayed, DCAing investor was given a choice between the unleveraged S&P 500 and the leveraged 2X option, he would have been best served with the leveraged choice, even with its daily settlement. That is, if he could have held his water through the faith-doubting, what-in-the-hell-am-I-doing 85% max. drawdown that occurred during the worst of the financial crisis. For the record, had it been me, I doubt if I would have held the course, which is the reason I never go all-in on a leveraged equity-only portfolio.

The 2X leveraged S&P 500 index wasn’t the only broad-market ETF on offer pre-2008. ProShares has had 2X leveraged ETFs that tracked and leveraged the DJIA, the NASDAQ 100, and the Russell 2000. These ETFs – the S&P 500 ETF included – have been split numerous times since their respective introductions. None have been reversed split, which is the typical response to excessive volatility decay and the concurrent withering share price. All four were introduced before the Great Financial Crisis. Though the ProShares 3X leveraged versions have the advantage of being introduced post-financial crisis, none of these has been reversed split, either. Remember, these things reboot daily.)

With all that said, some people find it impossible to get beyond the daily reboot because of the objections stated. Therefore, they are perceived as inappropriate for serious buy-and-hold investors. Most CFA charter holders and CFPs won’t consider them for portfolio inclusion.

I have conceded the inappropriate argument on the sector and individual stock ETFs. The price you pay for these more niche ETFs is oh-so-very important, as is the time you sell. As for the broad-market ETFs covering the four popular market indices (the DJIA is technically an average), the worries are exaggerated for the fundamental reason these broad barometers are inclined to rise over time. They spend more time rising than falling, so volatility decay isn’t the great killer it’s perceived.

That said, I remain open-minded, even as I creep closer to my dotage. If there is a better way, we should pursue it.

Perhaps we have a better way. A new class of leveraged ETFs was introduced a couple of months ago whose mission is to track their respective indexes more faithfully over time.

Tradr ETFs, a newish family of ETFs backed by AXS Investments, issued a bevy of 2X leveraged ETFs this summer. Unlike the leveraged ETFs offered by ProShares and Direxion, Tradr offers leveraged ETFs that reboot weekly, monthly, and quarterly. These ETFs aim to tamp down the volatility decay risk and reduce the tracking error that develops when daily-reset ETFs are bought and held. These ETFs could open the market to buy-and-hold investors.

Tradr offers three classes of ETFs that target the broader market – the S&P 500, the NASDAQ 100, and long-maturity U.S. Treasury securities (tracking the iShares 20+ Year Treasury Bond ETF). If these ETFs gain traction with the investing public, I expect to see similar extended date reset leveraged ETFs arise for other asset classes. (A leveraged ETF targeting shorter-maturity U.S. Treasury securities would be a nice start.)

They’re all brand new at this point, so we lack a track record to run with. For the heckuva it, I decided to see how Tradr’s 2X weekly (SPYB), monthly (SPYM), and, quarterly (SPYQ) reset S&P 500 ETFs compared to the 2X daily reset ETF, namely ProShares Ultra S&P 500 ETF (SSO). Tradr’s weekly and monthly reset ETFs have been around since August 30, so we’re talking only 11 weeks of trading.

Here are the returns of the Tradr and ProShares 2X leveraged S&P 500 over this meaninglessly short period. The ProShares daily reset 2X ETF gets the nod.

Tradr’s quarterly reset 2X leveraged S&P 500 ETF has been around since September 30, so we’re talking only seven weeks of trading. What the heck, let’s see what we get when the quarterly ETF is added to the mix. For what it’s worth, and it’s not worth much, the ProShares daily reset 2X leverage S&P again eked out the best return in the comparison.

Criticism (And a Refutation Thereof)

Volatility decay, tracking error, suitability; and let’s not forget expense. Ninety to 110 basis points annually is a lot to ask (though replicating the leveraging on your own is an expensive proposition.) What’s more, nearly all the sector and individual stock leveraged ETFs should be avoided by investors, including yours truly. I consider a leveraged sector ETF only if the discount is on par with the SOXX/SOXL scenario noted above.

But if we are focused on the broad market, let’s not dismiss out of hand the benefits of constructing intelligent portfolios and altering risk-return characteristics with leverage. I aver that for most investors this is the preferred avenue to pursue, as opposed to constructing portfolios through individual stock selection – seeking alpha, if you will.

I speak from anecdotal evidence: Most investors – accredited and qualified included – should eschew individual security selection. I have seen it time and again: An individual investor views each security as an entity upon itself, as opposed to a cog within a portfolio context. Every security, a stock in particular, will have its off moment – a quarterly earnings miss accompanied by downgraded guidance – that tanks the share price by some double-digit figure over a day’s trading. The other 14 stocks were unaffected, but the eyes fail to see the forest through that one stricken tree. It’s human nature to accentuate the negative, and then to do something regretful about it.

Our horizons aren’t limited to the classic 60/40 portfolio. ProShares and Direxion offer numerous leveraged ETFs to construct leveraged iterations of Ray Dalio’s All-Weather Portfolio, David Swensen’s Yale Model Portfolio, Harry Browne’s Permanent Portfolio, other popular “lazy” portfolios, or one of your devising. If Tradr’s long reboot leverage ETFs catch fire, I’m sure the longer dated reboot field will expand to include many of the daily reboot ETF varieties we see today.

With that said, my overarching concern isn’t with volatility decay and the accumulated tracking error. It is with the historical performance of a signification asset class — U.S. Treasury securities.

All historical performance numbers in my examples were generated over a period when bonds benefited from the favorable market backdrop that has persisted for most of the past 40 years. Did all that change in 2022? I don’t know. I do know that bull and bear bond markets are long duration. The bond market was mired in a bear market from the end of the Second World War until the early 1980s. The good news is that extended bond bear markets are generally less damaging than extended stock bear markets.

I’ll leave you with a final consideration: It need not be an all-or-nothing proposition. On the contrary, it shouldn’t be all-or-nothing proposition. There’s nothing wrong with dabbling with a sliver of the portfolio to get a feel for the process and see if you can withstand the ramp-up in price volatility and the threat of dyspepsia-inducing max. drawdowns. WisdomTree offers a get-your-feet-wet leveraged ETF with its U.S. Efficient Core Fund (NTSX). WisdomTree takes the classic 60/40 and leverages it to 90/60. Moreover, it leverages on the cheap at 20 basis points annually.

For now, I’m tracking the new vintage of extended reset leveraged ETFs to see if they overcome the shortcomings of the daily-reset variety. I will be particularly interested in the quarterly reset leveraged ETFs to see if the concept extends to other asset classes (shorter-term U.S. Treasurys, in particular). If they prove successful and superior to the original, then out with the old and in with the new.

Now for the fine print: I have no relationship – business or personal – with any of the companies mentioned. I don’t know them; they don’t know me.

I own many of the investments mentioned in this article. They are appropriate for me, they may be inappropriate for you.

DYR (Do Your Research). I have opinions, but I am not your investment advisor. What works for me might not work for you. For most people, the strategies mentioned here will not work because of the risk tolerance involved and discipline required. NOTE THE MAXIMUM DRAWDOWN. Always remember the buck stops (and starts) with you, and you know you better than anyone.

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