How to Use Leveraged ETFs

In this video, I’ll show you the right way to use leveraged ETFs.

Their high volatility requires a set of defined reactions.

Leveraged funds were first offered to investors in the early 1990s. The first leveraged ETFs appeared in 2006.

The idea behind leveraged funds is to increase an investor’s performance by magnifying the movement of an index.

For example, the SSO ETF seeks to provide twice the daily movement of the S&P 500. If the S&P 500 rises 1% on Tuesday, SSO should rise 2% on Tuesday. If the S&P 500 falls 2% on Friday, SSO should fall 4% on Friday.

Other ETFs provide 3x leverage. There’s also inverse 2x and 3x leverage, where the ETFs move twice and three times farther than the index in the opposite direction, thus rising when it falls and falling when it rises.

In all cases, the leverage is applied daily.

Eager investors drew the hasty conclusion that this doubling and tripling of performance could be applied to longer time periods. “If the market rises 10% this year, I could make 20% by just owning a 2x ETF,” they thought.

But it’s not that simple.

Because the daily performances of the index are magnified, the difference in the leveraged ETF’s performance over time will not be exactly 2x or 3x the index’s.

It’s easy to demonstrate why.

If an index starts at 100, and drops by 20% one day and 20% the next day, it’s down to 64. Would rising 20% each of the next two days take it back to 100?

No. It would take it back to just 92. Why? Because 20% of 64 is not as much as 20% of the initial 100.

Starting from the smaller place it ended up after falling, the index needs a greater percentage gain than the decline that preceded it, in order to return to its pre-decline value.

In total, the index needs to rise 56% from 64 in order to regain 100.

If this is the case, wouldn’t leverage magnify the problem? Sure it would, because all numbers are magnified, specifically by 2x and 3x on a daily basis.

Instead of falling 20% one day and 20% the next, a 2x leveraged ETF of this index would fall 40% one day and 40% the next. From a starting level at 100, this would take it down to 36.

To recover from 36 back to 100 would require a 178% gain, more than twice the 56% needed by the index.

Seeing this situation, the financial media made a different hasty conclusion about leveraged ETFs. They boldly declared that “Leveraged ETFs decay over time. They are not suitable for buy-and-hold investors.”

For example, look at this story in the Wall Street Journal on May 11, 2012: “Beware ‘Leveraged’ ETFs.”

[Story screen capture in the video, at 3:40.]

Here’s another, this one from Business Insider on September 21, 2016 titled: “Buyers Should Beware of This $3 Trillion Market.”

[Story screen capture in the video, at 4:05.]

These articles and many others like them warn that due to the daily tracking issue I just explained, investors should avoid leveraged ETFs.

While it’s true that leveraged ETFs are not for everybody and must be managed with care, the daily tracking issue is not a flaw that makes them unusable. There are two reasons why.

First, even though buying and holding leveraged ETFs is not the preferred way to use them, it actually does work out in most long-term time frames.

The market rises more often than it falls, and big crashes are rare, so while it’s possible to find time frames where the leveraged ETFs trailed their indexes, they usually come out ahead.

For proof, look at this shot from my website’s Strategies page, at jasonkelly.com/resources/strategies:

[Performance table in the video, at 5:05.]

The table shows the growth of $10,000 without dividends, just price change, from the end of 2002. This screen capture picks up at the end of 2004.

The first column shows the $10K’s growth in the plain Dow without leverage.

The third, titled “Double The Dow,” shows it in a Dow 2x fund. The fourth, “Maximum Midcap,” shows it in a Midcap 2x fund.

All of these are just buy-and-hold.

Were the Dow 2x and Midcap 2x funds a disaster, something to beware of? Not at all. After they were crushed along with everything else in the subprime mortgage crash of 2008, they roared back.

By the end of 2016, look how much farther ahead they were than the Dow:

[Performance table top row in the video, at 5:56.]

The Dow ended 2016 having grown $10,000 to just $23,472. Double the Dow, or Dow 2x, grew it to $39,394. Maximum Midcap, or Midcap 2x, grew it to $60,984.

Dow 2x didn’t perfectly double the Dow’s balance, but it delivered a much bigger performance than the Dow’s and that’s good enough, certainly within the spirit of what the leverage is supposed to do.

So, while it’s a fact that setbacks become magnified in the leveraged funds, it is not true that they are certified disasters over time periods longer than a day.

The second reason why media warnings against leveraged ETFs need to be understood in context, is this: If the ETFs are used the right way, the daily tracking issue becomes a strength, not a weakness.

Leveraged funds are simply more volatile than non-leveraged. They follow the index’s same directional moves, but rise more and fall more.

That’s all. If you react appropriately to these rises and falls, then they work for you, not against.

I use a 2x and a 3x ETF in The Kelly Letter within a predefined framework of reaction to their magnified moves.

On a quarterly basis, so just four times per year, I look at their prices in relation to a growth target line.

If they’ve delivered surplus profits above the target, I sell the excess and put it in a safe bond fund. If they’ve fallen short of the target, I buy the shortfall with money from the bond fund.

This process works with both leveraged and non-leveraged funds, but the higher highs and lower lows of leveraged ETFs can make it work better. The reason is straightforward: they present bigger profits and bigger bargains due to their wider zones of fluctuation.

This is the right way to use leveraged ETFs.

To sum up, while the media are right to warn investors about the dangers of higher volatility in leveraged ETFs, they are wrong to state that the ETFs cannot work over the long term due to “performance decay.”

In fact, they can work even in a buy-and-hold approach spanning years.

But a much better way to use them is with an automated system of extracting excess profits and buying excess bargains, both of which are delivered by leverage.

I hope you found this to be helpful. If you did, please like and subscribe.

You can learn more about the way I use leveraged ETFs in The Kelly Letter at jasonkelly.com.


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Thank you for watching!

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One Comment

  1. Posted February 18, 2017 at 7:44 am | Permalink

    If I sign up for the monthly sub do I receive the free book also-sorry tosound cheap,but thought I would ask.!

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