In Defense of Leverage

It seems everybody thinks they’re a wizard these days to point out that leveraged mutual funds and ETFs are daily tracking vehicles, and “suitable only for daytrading!”

There’s a valid point to be made about slippage, but it goes only like this: steeper falls require steeper rises to get back to even. A series of steeper falls will put a leveraged product very far behind its target index, and in some time frames will lead to results that don’t match what you’d expect.

Then again, can’t we say the same thing about plain vanilla indexes right now? Who among the investment community expected to make zero profit on money invested in the S&P; 500 in 1996? Nobody, but here we are back at those levels.

Regarding the daily performance objective of leveraged funds and ETFs, so what? Because they’re computed on a daily basis does not mean they have only daily usefulness. Every investment posts a daily performance, and its longer-term performance comes from the sum of its daily performances. Can leverage adversely affect longer terms? Yes. Can it have a positive effect? Yes.

The typical example to illustrate that leverage is bad shows that when the S&P; 500 loses 25%, it requires a 33.3% gain to get back to even. A 2x fund or ETF that loses 50% while following the index requires a 100% gain to get back to even. Gains of 100% are a lot harder to come by than gains of 33%, so the leveraged product is doomed to fall farther and farther behind. The math makes sense, and it’s true that you don’t want to buy a leveraged ETF or fund and hold it forever.

Then again, forever is a long time. You can do pretty darned well with leveraged products in time frames that are pretty darned long. In the five years from December 2002 to December 2007, a $10,000 investment in the Dow via DIA became $15,752. In the Dow 2x mutual fund UDPIX, it became $21,097. In the MidCap 2x mutual fund UMPIX, it became $28,495. In the SmallCap 2x mutual fund UAPIX, it became $31,614. Those results are from simple buy-and-hold strategies, not daily checking and trading. Naturally, all four crashed in 2008 and so far this year, too — along with everything else.

In more recent, shorter time frames, we’ve seen leveraged products working very well for swing trades. From the Nov. 20 low to the Jan. 6 high, for example, the S&P; 500 via SPY gained 24% but its 2x follower SSO gained 49%. You may notice that despite the critics screaming that it tracks 2x only on a daily basis, it still managed a better than 2x performance in this seven-week period. That’s a decent holding period, certainly reasonable for a swing trade, and the tracking was fine.

What I tell subscribers regularly is that these leveraged products won’t get their tracking perfect, but they’ll get it right in spirit. The 2x and 3x products will rise more than what they track in a time frame with an upward sloping trend.

Yes, I’ve seen the examples of time frames with high volatility that nets out to zero where these products fall behind a flat index. Yet, does it take much thought to conclude that, of course, you want to own leveraged products on a rising trend? No, and it’s conveniently the same goal as when you invest in the plain non-leveraged index. The upward slope is every buyer’s target. To criticize leverage because it didn’t work in a flat or falling environment is to miss a key point: neither did the target index. You’re looking for a rising slope anyway, so it’s convenient that when you find one you’ve also found a situation where leverage will help you.

You know what else is convenient but widely forgotten now? The market rises two-thirds of the time and falls one-third. At some point in this bear market, stocks will bottom. A recovery will start. Indexes will begin to rise. Moving averages will go from down to flat to gently upward to more steeply upward. When they do, even people in it for longer than days or weeks will be happy to own a product that gains twice or thrice the index returns, even though that outperformance is computed on a daily basis.

Do we need to be careful with leverage? Yes. Because we’re in a bear market, everybody is obsessed with danger and eager to point that out. The flip side of more risk, however, is more reward — and its day will come again.

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