[Editor's Note: Here at WCI we try to keep things as simple as possible, most of the time. Not today though. Today we're going to be discussing leveraged ETFs, a classic example of a product meant to be sold, not bought. This is a guest post from Chase R. Cawyer, MD, MBA, a financial advisor at Navigo Wealth Management in which he proposes a strategy to profit from the issues with leveraged ETFs. The publication of this strategy here should not be taken as an endorsement of the strategy, but simply a reflection that I found it interesting to think about myself and thought it would make for a good discussion. He is a paid advertiser on the site (although this is not a paid post.)]

Leveraged ETFs (Exchange Traded Funds) and Leveraged Inverse ETFs are a sucker’s bet, right?  That’s mostly true when buying them as long positions.  Leveraged ETFs inherently deteriorate in value due to their structure and inefficient daily resetting process and as WCI and many others have correctly mentioned, it is generally wise to avoid buying these products.  But what about doing something else with them besides buying them?  After all, inefficiencies often breed opportunities.

Beta Slippage

ProShares Ultra (SSO) is a leveraged ETF that seeks to return 2x that of the S&P500. As reiterated from their literature “The Ultra Proshares seeks a return that is 2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next.”

Chase Cawyer, MD, MBA

Chase Cawyer, MD, MBA

The performance problem with leveraged funds is that they deteriorate with what is called beta-slippage. To best illustrate, take a very volatile asset that is up 43% one day and down 30% the next. Compare it to a perfectly double leveraged ETF that should go up 86% one day and down 60% the next and see the end results:

Primary Asset:   (1+0.43) x (1-0.30) = 1

“Perfectly” leveraged ETF:  (1+0.86) x (1-0.60) = .74

As you can see the “perfectly” leveraged ETF has lost 25% of its value just due to beta-slippage. This is not some scam to take away your money, and nothing has changed in the principal asset, but simple mathematics has prevailed. Now this is an extreme example, but even if you adjust the percentage to something more realistic (2.5% up and 2% down) you will still see the impact of beta-slippage, especially over time.

For every positive there is a negative, and in the case of leveraged ETFs that is certainly true with the introduction of inverse leveraged ETFs.  Instead of attempting to return 2x the S&P500 (SSO), traders can “invest” in Proshares UltraShort S&P500 ETF (SDS) and do the opposite. “The Short Proshares seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next.”  Thus, when the market goes down 1% in a day, those invested in the fund hope to achieve a gain of 2% for their positions.

As previously mentioned, Leveraged ETFs, including the inverse versions, are not usually advisable funds to invest in. They reset every single day, and as we know all trades come at a cost to those who make them. Plus, beta slippage over the long-term distorts the risk/reward. See the following chart of the performance of SPY (green), SSO (blue) and SDS (red) from Nov 2010 to Nov 2011.

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SSO / SDS Leveraged ETFs Pair 1 Year Chart from November 24, 2010 (Yahoo!)

As you can see, SSO did not return 2x the S&P 500 (SPY), not to mention SDS’ abysmal return compared to what it was intended to do. If asking if those poor returns are due to higher costs to make daily trades or due to beta-slippage, the answer is YES!  And although these instruments are intended for day traders, investors can take advantage of them. If the value of leveraged ETFs inherently goes down, then investors can actually capture that value through short selling.

Short Selling Inverse ETFs

Now when most people hear the term short selling they scream risky proposition, but let me show you how it can work when done in an appropriate manner. For a brief recap short selling is defined by Investopedia “as the selling of a security that is not owned by the seller, or one that the seller has borrowed. Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit.”

If you’re fully long in the stock market at all times you wouldn’t even think that shorting the 2x leveraged S&P 500 (SSO) would be a good idea. But, what is your reservation for shorting the inverse leveraged S&P 500 (SDS)? The double negative makes it a positive.  In other words, being short an inverse fund in this case, means you are essentially long and own twice the S&P 500.  You should be able to buy it back at a lower price at any point in the future because of the natural deterioration, correct?

For instance, if you shorted SDS at inception on May 31, 2008 you could have sold it (remember you’re shorting so think backwards) at 185.18 (adjusted close) and bought it back at 18.07 on May 31, 2016 for a total return of 925% (>110% annualized over those 9 years). Now before you start talking about how that number is too good to be true let me tell you it absolutely is.  But the point is, if you understand the inefficiencies of inverse leveraged ETFs and know how to take advantage of those, then why wouldn’t you?

Dealing with Risk


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Shorting, leverage, inverse, huge potential returns…it all sounds too risky.  It could be, but let’s take a look at how to take advantage of these inefficiencies more practically and safely.

First, shorting can only be done in a taxable investment account. In addition, all shorting gains are taxed as a short term capital gain thus your tax bracket matters. For example, using the 35% tax bracket you have to pay 35% of each year’s gains in taxes reducing that total return to 436% (48% annualized). As if we all needed another reason to show us why we should first invest in tax-deferred accounts.

Next, you likely wouldn’t want to go 100% equities because remember these funds are volatile. As a matter of fact, look at the start of the initial investment to the end of the bear market (June 2008 – Mar 9th, 2009).  If you had shorted SDS, you were looking at a net loss of 150%!! So how do you decrease volatility? Asset Allocation. So maybe a nice 60/40 stock/bond split is the way to go.  You don’t want to do just any ordinary bond fund, however.  You want to use the same shorting strategy on a leveraged inverse ETF to capture that deterioration.  Enter Ultrashort 20+ Year Treasury (TBT) as the fund of choice resulting in a 60/40 short mix of SDS/TBT. This matters because if invested 60/40 SDS/TBT during that same bear market stretch, while your SDS short was down over 150%, your TBT short was up almost 60% resulting in a still terrible but much more palatable 66% loss (compared to the S&P loss of 51%). Since the massive drawdown of our short positions was diminished, the net return over the entire 9 year time frame was actually improved to 495% (62% annualized).

Our results show that you would have been able to crank out some incredible gains over time, but we know how strong an emotion fear is. While the balanced portfolio did generate 62% annualized gains over the 9 year time frame, had you been watching the maximum drawdown of 66% you would have been fearful and questioning the validity of the strategy during that time.  So how about exchanging some of the volatility for lower annualized returns?  If you were to hold at least 50% of the portfolio in cash thus resulting in a 30/20/50 portfolio (SDS/TBT/Cash), you would have dramatically minimized the overall portfolio volatility while experiencing a total after tax return of 158%, or 19.7% annualized. This not only reduces our drawdowns significantly (a maximum of 33%); it reduces your stress level as well.  It also addresses any margin call issues that might come into play if you were not sitting on much cash.

How does this more conservative 19.7% annualized return compare to a basic stock/bond portfolio mix during that same time frame?  Very well!  A buy/hold S&P 500 ETF (SPY) returned 7.1% after tax while a balanced portfolio (60% stock, 40% T-Bond) showed a higher 8.5% return.  An even more conservative strategy holding 70% cash and being short 18%/12% SDS/TBT still outperforms the market with a net 10% annualized return on investment.  So we have found an ability to handily beat the market by being long the S&P 500, long 20 year Treasury bonds, and holding 50-70% cash.


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When you short a leveraged ETF you are essentially going long a balanced portfolio of stocks and bonds, but then continuously capturing the value/money that deteriorates due to the inefficiencies of these positions. This type of shorting strategy can be incredibly volatile and obviously not for everyone, but with volatility (risk) comes rewards.  You can move along that risk continuum as much as you like by including a lower cash allocation, which heightens the volatility, or a higher cash allocation, which dampens the volatility.

This strategy would generally be recommended with only a portion of an overall portfolio and the concept, along with other strategies that take advantage of market inefficiencies, can be utilized to create a more aggressive tilt to your portfolios.  Our experience has shown that by also adjusting allocations dynamically based on the prevalent market environment you can even enhance returns further, especially in a bear market, while simultaneously reducing volatility; but that is an article for a future time.  Although this strategic idea can appear somewhat complex, having an advisor experienced with this type of approach can take some stress off the table, but for those who manage their own investments the execution of this static approach is relatively straight forward. With a simple approach using large amounts of cash as a strategic allocation as described above, market beating returns with reasonable risk are certainly on the table. When looking at the current investment climate, and shaking your head at how many inept/terrible investment funds there are, a smart shorting strategy that takes advantage of inefficiencies can result in huge dividends.

[Editor's Note: I'm not sure I'm smart enough to point out all the potential issues with this strategy. Obviously I think going along with any of these investment products for the long-term is dumb. I've never owned a leveraged ETF and don't plan to start now, long or short. We have a written investment plan that we follow and it doesn't include schemes like this. A physician certainly doesn't NEED to use strategies like this to be financially successful. But I do like the idea of profiting from stupid investment products. However, there are a few things that are worth thinking about if you are considering adopting this sort of a strategy for a very small portion of your portfolio.

  1. If it is really all that smart, why isn't there a hedge fund already doing this? Well, it turns out there is. In fact, it was the best-performing hedge fund in 2015. That gives me a weird sense of performance chasing in my gut.
  2. This strategy is expensive. Not only are the expense ratios of these ETFs 10-20 times the cost of a good Vanguard ETF, but the continual buying and selling adds up too.
  3. The tax issue is not insignificant. What is your marginal tax rate? Mine is over 40%. Seems like a lot of risk to take to only keep half the gains.
  4. As a general rule, when a strategy is shown to be good (as this one apparently has in the recent past), it gets arbitraged away. I'm not sure exactly what that would look like for these leveraged ETFs, but perhaps it would manifest itself by making it harder to find shares to short (none to borrow on the market) or perhaps there would be a a negative premium on them.
  5. In a really impressive market (i.e. a trend that keeps going), your losses are infinite. When you short something, you HAVE to buy it at whatever price it is selling at later. That might be more money than you have. I could imagine a scenario where beta slippage decreased somehow and the market rapidly increased or decreased and wiped you out. Read this account of a guy who took a pretty good loss doing this 5 years ago.

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  6. Like any strategy, staying the course is challenging. Dr. Cawyer's recommendation to do so is to hold a bunch of cash, which is at best paying 1% right now. You think it's tough holding an 80/20 portfolio? Try one with a bunch of shorts and leveraged ETFs. If you're paying attention, you'll be pitched an apparently promising investment strategy at least once a month throughout your investing career. Bouncing from one to the next is the worst possible investing strategy. Investing is more behavioral than math. Even if you're the type who can tolerate a strategy like this without an advisor, will your spouse be able to if something happens to you? And if you need the advisor, add on another layer of fees.

Overall, there is some promise here, but I think the negatives are enough to keep me from implementing this with even 5% of my portfolio.]

What do you think? What issues do you see with this strategy? Is there a free lunch here? If not, are the potential returns worth the price of entry? What percentage of your portfolio would you use to implement something like this if you were convinced of its merits? Comment below!