A more generic explanation for why levered ETFs suck (aside from the ludicrous fund management fee).
Case of the 4 Seemingly Similar Funds
Given the following 4 funds, which fund would you want to invest in?
Fund A Fund B Fund C Fund D Year 1 0% 20% 5% 10% Year 2 10% 10% 10% 10% Year 3 20% 0% 15% 10%
Each of the funds delivers the same average annual return of 10% and the same additive return of 30% over 3 years, but via different pathways. So the questions here are: 1. is it better to have bigger returning years at a cost of volatility? and 2. would you rather have the bulk of your returns up front or towards the end / would you rather be returning a higher percentage on less money or a lower percentage on more money?
Fund A Fund B Fund C Fund D Avg. Ann. Return. 10% 10% 10% 10% Actual 3 Year Return 32% 32% 32.825% 33.1%
Though the 4 funds post the same average annual returns of 10% over the same 3 year period, Fund D has the best total returns. Funds A and B show that your total return is independent of when you get your big returning years. Fund C shows slightly less volatility of returns than funds A and B but more than D, and therefore a net return in between. Fund D has the same average return, but zero volatility of returns and the highest actual return on investment.
Volatility dampens returns.
Leveraged ETFs = Increased Volatility
In the example of 4 funds above, the increased volatility will tend to cannibalize your returns. Now imagine that on a day to day basis with 2x or 3x levered funds.
The leveraged funds are, for the most part, designed to replicate their target leverage ratio on the day over day returns on their target index.
Fund 1x Fund 2x Fund 3x Fund 4x Day 1 +2% +4% +6% +8% Day 2 -5% -10% -15% -20% Day 3 +4% +8% +12% +16% Day 4 -1% -2% -3% -4 Simple Sum of Daily Returns 0% 0% 0% 0%
A naive investor might think that a constant leverage portfolio might have the same amount after these 4 days…
Fund 1x Fund 2x Fund 3x Fund 4x Percentage of Initial Capital Remaining 0.9977 0.9907 0.9788 0.9622 Loss 0.23% 0.93% 2.12% 3.78%
Its not that levered funds are always losing propositions. Being right about short term direction will still be rewarded, but maybe not as much as you might think.
3 responses so far ↓
1 Allen Taylor // Nov 29, 2008 at 4:31 pm
Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor
2 Dustin // Dec 10, 2008 at 4:20 pm
Fatty,
I’ve been playing w this myself. Understanding that history doesn’t necessarily repeat itself, if I had invested $1 into the 1978 djia index, I would now have $10.62847604. If I were to have done the same with $1 into a 2x fund, I would now have $42.7593261, and if I were to have done $1 into a 3x fund, I would now have $58.62240579. This is neglecting ERs, but it’s still impressive. These are real world numbers and not just a theoretical example as you see here, over the long run in a market that you know is going to go up, leveraged returns are your best friend.
3 mark // Dec 12, 2008 at 5:49 am
indeed, if your avg rtn is positive year over year, then leverage is your friend. Consider that western markets avg rtn is 10% would you rather have 10 on average or 20? or 30? im not necessarily advocating making directional calls on a daily/weekly basis b/c then it becomes a game of roulette and the house/mkt will probably eat ur ass for lunch. however, in the long term these are another tool to generate returns which i think is a good thing.
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