By: Larry MacDonald
A Nobel-Laureate gave some investment advice 50 years ago. The Laureate was Yale University professor James Tobin and his advice was: the optimal portfolio for the long-term investor is indexed to the market and leveraged.
If the market has historically yielded an average 8% to 10% annually over the long run, then borrowing to double exposure to the market would return over 16% to 20% a year (before expenses) to the long-term investor.
Buying stocks on margin has its problems, of course. Interest rates on debt cut into the returns. And if the investor doesn’t have the cash or nerve to respond to margin calls during market corrections, the approach loses its advantages.
Leveraged exchange-traded funds (ETFs) offer fresh hope for the leveraged indexing approach. They don’t have margin calls. And costs appear to be low – annual fees are in the vicinity of 1%. An example is the ProFunds Ultra S&P 500 ETF (SSO), which delivers twice the daily performance of the S&P 500 Index.
Alas, there are substantial caveats on using leveraged ETFs for long-term investing. Tristan Yates of investment advisory Index Roll explains them well. They are also summarized in this article.
A solution may be to rebalance one’s position in a leveraged ETF. As it goes down an investor buys more and as it goes up, they sell off units. This can offset the change in market exposure due to the daily rebalancing that the fund has to do to maintain its leverage factor of two.
The Horizon BetaPro family of leveraged funds offers a “rebalancing tool” on their website for such a purpose. I asked Tristan Yates what he thought of it.
“Using the term ‘rebalancing’ might make you think that you’re maintaining your original index exposure over time,’ he said, “but that’s not the case.” It only directs investors to make up half the loss of exposure. If the index falls $1, investors take losses of $2 and index exposure falls $2. “If you wanted to keep the exposure constant, you would have to contribute $2….” But the tool just asks for $1.
It provides protection but just half way against the constant leverage trap. Investors could conceivably then rebalance with double the amount the tool tells them. That way the leveraged ETF should be more assured of returning close to twice the index (before fees) over long periods.
A challenge, though, is the sums involved when extreme situations arise. If the index falls 40% to 50% over time, the amount to be added to the ETF according to the tool (without doubling up) “could cumulatively equal or perhaps even exceed the original investment,” Mr. Yates warns.
So, annual average returns of 16% to 20% (before fees) may be possible but getting there may require more emotional and financial discipline than most investors have. And after fees, including the fund’s transaction fees etc, the net return might come in closer to 12% to 16% a year. That’s better than unleveraged ETFs but is it worth the hassle? Thoughts anyone …?
7 Responses to “ The optimal portfolio? ”
Hi Larry,
I think the net return is likely to be less than 12% to 16%. Part of the fees is the interest on borrowed money, which will be above the bank prime rate for substantial portfolios. There are also losses on the long-term compounded return due to the doubled volatility. This is all in addition to any fund transaction fees and taxes.
By Michael James on Oct 25, 2008
How would you trade in this market.
I have HXD and add/subtract half positions depending on market direction.
So far I been adding with some luck.
By Dennis on Oct 25, 2008
Michael
Thanks for your feedback. The leverage is assumed by the ETF through index futures, swaps,and other derivatives. Isn’t the lending rate closer to the yield on treasury bills on such instruments? Leveraged funds also have large cash holdings and earn interest on that too. So wouldn’t the net rate be lower than prime?
By Larry MacDonald on Oct 25, 2008
Denis
So far it’s the kind of market to short on the rallies and go long on the dips. Good luck with the HXD.
By Larry MacDonald on Oct 25, 2008
Hi Larry,
When leverage is obtained by borrowing, the lender demands an interest rate that compensates him for the risk of default. For any sane lender, this rate must be higher than the rate on treasury bills. There is no free lunch when leverage is obtained using derivatives. The net effect of the returns from the derivatives plus any interest on cash holdings will work out to roughly the same return as the case where leverage is obtained by borrowing. Otherwise, there will be an arbitrage opportunity. The prices of futures and swaps will adjust to keep the two different methods of creating leverage in balance.
By Michael James on Oct 26, 2008
You are correct James. Some of the problem is marketing, as people are led to believe that they will get double the daily return of the index and later realize that there’s interest costs, transaction costs, and expenses involved that reduce the return.
The other problem is that people don’t understand how quickly their index exposure can change. Example: Market falls 20%. Your leveraged ETF falls 40%. (Forget interest for now.) Now the index rises +25% to make up its losses. You get a +50% return… but wait, losing 40% and then getting 50% only gets you back to 90% of your original value. That’s the trap you fall into, and over time as the market moves up and down a lot you end up actually underperforming the index.
And the third issuesis the costs – yes I mentioned them before, but whatever the built in expenses happen to be, they are extremely high and your payoff starts to look like 2X the daily index return minus one days’s interest at an 8% APR.
I’ll add in one more problem, just an annoyance – why is the doubled daily return sometimes so far off from the index? Quite often its a full point or two off. Sure, the difference is usually made up in a few days, but it just seems like there’s always some tracking error.
They are fascinating securities to study and I do think the idea of incorporating futures and forwards into an ETF is novel and would like to see more products do this. I just don’t think this specific product works well for medium or long-term investors that aren’t willing to rebalance on almost a weekly basis. (tristan at indexroll dot com)
By Tristan Yates on Nov 8, 2008
Michael,
There are brokerages offering margin at less than two percent today. Try Interactive Brokers.
The leverage strategy does work.
By Roderick S. Beck on Sep 12, 2009