If I understand correctly your analysis shows that the strategy with leveraged ETFs outperforms the strategy without leverage (and is indeed comparable to leverage on margin). Is there an underlying frequent rebalancing or other effect that I am missing?
My understanding was that leveraged ETFs are only useful for day trading and not for long-term buy-and-hold because of the internal re-adjustment to the index each day. If that holds then I would expect the better returns you show to be an artefact of the chosen time period, but find it still surprising!
Is there an underlying frequent rebalancing or other effect that I am missing?
Rebalancing is required. My example rebalanced after a 10% deviation, but you’d get very similar performance by rebalancing monthly.
My understanding was that leveraged ETFs are only useful for day trading and not for long-term buy-and-hold
That does seem to be a common misconception, but it’s easily shown to be false. A (e.g.) 3x daily ETF tracks at 3x per day. Over longer periods, due to compounding, this accelerates your returns (even your negative returns), so don’t expect performance to be 3x over periods longer than a day. Results can be even higher than 3x for instruments that tend to trend up in the long term, which stocks and bonds do.
I’m not sure the linked article shows it to be false, exactly. If you look at the first graph, you can see that over 135 years of US data, 1x leverage returns about 4% annually, and 2x leverage about 5%, with double the risk. That’s pretty bad, unless you’re desperate for risk.
Now, that plot doesn’t include dividends, which are an important part of the calculation. And using different countries or time periods will give different results, as they demonstrate later on. Still, if you’re discussing a type of investment the SEC specifically warns people about, there might be more to say here?
Leveraging up, on its own, is never going to improve your Sharpe ratio. But you can use leverage to get a better return if your portfolio is below your risk tolerance, at least until you hit the optimal bet size.
Volatility does have bad effects on leverage, which is why my somewhat safer system reduces the leverage for an asset when its vol is high, even below 1x, if necessary, by holding cash. The Kelly strategy means there is always an optimal amount of leverage, and it’s unlikely to be exactly 1x.
Well, Kelly is optimal if you have infinite time, or logarithmic utility. In practice we all have finite time, and many of us are more risk-averse. Plus, as you mentioned earlier, Kelly is only optimal if you know the payoff distribution, which you don’t.
I’m not saying leverage can’t be a useful addition to a portfolio; just that there are also reasonable concerns about it. Yes, a leveraged mix of equities and bonds has done pretty well the past forty years. But the thirty before that, it was a disaster. Sure, the macroeconomic regime was different then; but in a world of negative interest rates, are you sure it won’t change again?
Sure, the macroeconomic regime was different then; but in a world of negative interest rates, are you sure it won’t change again?
Nope. We are not trying to avoid all risk. We’re trying to get exposed to risk so we can get paid for it. The right side is uncomfortable. Taking on the risk of bonds crashing, in the appropriate amount, so we can get paid for it, is exactly the point of adding leveraged bonds to a risk premium portfolio. If it weren’t risky, there wouldn’t be a risk premium for holding it. People on the margins have been forecasting the end of the bond bull market for years. If you had listened to them then, you’d have given up the returns up till now.
If you play the game long enough, risks will eventually bite you. You will have drawdowns. Don’t Bet the Farm. But the market pays you extra for it. You’ll still eventually come out ahead if you size your exposure appropriately.
Thanks for the link and the insights, I just did a small toy calculation to check and my intuition was wrong: There seems to be much more to leveraged ETFs, like you say!
If I understand correctly your analysis shows that the strategy with leveraged ETFs outperforms the strategy without leverage (and is indeed comparable to leverage on margin). Is there an underlying frequent rebalancing or other effect that I am missing?
My understanding was that leveraged ETFs are only useful for day trading and not for long-term buy-and-hold because of the internal re-adjustment to the index each day. If that holds then I would expect the better returns you show to be an artefact of the chosen time period, but find it still surprising!
Rebalancing is required. My example rebalanced after a 10% deviation, but you’d get very similar performance by rebalancing monthly.
That does seem to be a common misconception, but it’s easily shown to be false. A (e.g.) 3x daily ETF tracks at 3x per day. Over longer periods, due to compounding, this accelerates your returns (even your negative returns), so don’t expect performance to be 3x over periods longer than a day. Results can be even higher than 3x for instruments that tend to trend up in the long term, which stocks and bonds do.
(This is not financial advice.)
I’m not sure the linked article shows it to be false, exactly. If you look at the first graph, you can see that over 135 years of US data, 1x leverage returns about 4% annually, and 2x leverage about 5%, with double the risk. That’s pretty bad, unless you’re desperate for risk.
Now, that plot doesn’t include dividends, which are an important part of the calculation. And using different countries or time periods will give different results, as they demonstrate later on. Still, if you’re discussing a type of investment the SEC specifically warns people about, there might be more to say here?
Leveraging up, on its own, is never going to improve your Sharpe ratio. But you can use leverage to get a better return if your portfolio is below your risk tolerance, at least until you hit the optimal bet size.
Volatility does have bad effects on leverage, which is why my somewhat safer system reduces the leverage for an asset when its vol is high, even below 1x, if necessary, by holding cash. The Kelly strategy means there is always an optimal amount of leverage, and it’s unlikely to be exactly 1x.
(Still not financial advice.)
Well, Kelly is optimal if you have infinite time, or logarithmic utility. In practice we all have finite time, and many of us are more risk-averse. Plus, as you mentioned earlier, Kelly is only optimal if you know the payoff distribution, which you don’t.
I’m not saying leverage can’t be a useful addition to a portfolio; just that there are also reasonable concerns about it. Yes, a leveraged mix of equities and bonds has done pretty well the past forty years. But the thirty before that, it was a disaster. Sure, the macroeconomic regime was different then; but in a world of negative interest rates, are you sure it won’t change again?
Nope. We are not trying to avoid all risk. We’re trying to get exposed to risk so we can get paid for it. The right side is uncomfortable. Taking on the risk of bonds crashing, in the appropriate amount, so we can get paid for it, is exactly the point of adding leveraged bonds to a risk premium portfolio. If it weren’t risky, there wouldn’t be a risk premium for holding it. People on the margins have been forecasting the end of the bond bull market for years. If you had listened to them then, you’d have given up the returns up till now.
If you play the game long enough, risks will eventually bite you. You will have drawdowns. Don’t Bet the Farm. But the market pays you extra for it. You’ll still eventually come out ahead if you size your exposure appropriately.
Thanks for the link and the insights, I just did a small toy calculation to check and my intuition was wrong: There seems to be much more to leveraged ETFs, like you say!