A brief article I came across today fascinated me. It was about a lawyer who traded in his part time and made a wild bet that struck it rich, but in a way that flies in the face of conventional wisdom.

In February of 2010, after a series of bad investments in things like natural gas, oil drilling and Lehman Brothers, an anonymous Reddit trader known as “Throwaway” remained bullish on the long term prospects for the stock market. Unlike most of us (this author included), rather than just going long a few large cap stocks or index funds, this trader claims he invested all of his funds in 2 leveraged ETF’s: Direxion Financial Bull 3x shares (FAS) where he invested $100,000 and Direxion Daily S&P 500 Bull 3x shares (SPXL) in which he invested $70,000. He shared a screen shot of how these two investments had turned into $1.5 million, an annualized return of about 24% over almost 10 years.

Source: Market Watch

This got me thinking about leveraged ETF’s and all the commotion they caused when they were introduced just before the crisis. The experts weighed in and cautioned long term and retail investors to stay away from these ETFs but the results of this investor seem to fly in the face of all the accepted logic and to his point, take a look at SPXL versus the S&P 500 over the last 5 years. It has more than tripled the return of the S&P 500 over this period, but why is that?

Source: Yahoo Finance

A Little Primer on Leveraged ETF’s

Leveraged ETF’s have a pretty simple goal, they try to return some multiple of an underlying index on a daily basis. For example, SPXL tries to deliver a daily return that is three times the return of the S&P 500. The key word here is daily, these ETF’s only attempt to produce a leveraged return in one trading day. In the case of SPXL, the assets and liabilities are then rebalanced at the end of the day to deliver the same 3x performance tomorrow. These ETF’s are able to provide returns like this by entering swaps and derivatives which can mimick the leveraged return of the index. Due to the daily rebalancing of those instruments though, there may be significant drift from the performance of the index and what should be the leveraged return of the index over the long term

One day returns are simple to understand, let’s use the example of SPXL and the 3 times leverage again. If the index is up 1% SPXL is up 3%. Likewise if SPXL is down 1%, SPXL is down 3%. However the ETF levers up for 3 times the return the next day and needs to make up even more ground if there was a sharp move downward. This is known as volatility drift.

To show it with a numerical example think of a $10 security called ABC and a 3 times leveraged security based off of ABC called XYZ. If ABC moves up $1 the share price is $11, then XYZ will move up to $13. If ABC falls to $9 then XYZ will fall to $7. Each is a move of 10% for ABC. After losing $1 or 10%, let’s assume ABC then moves back up 10% to $9.90. The two day return from moving down 10% then up 10% for ABC is -1%. For XYZ though the move would be down 30% to $7 then up 30% to $9.1 which produces a 2 day return of -9%. This is the daily compounding effect. And the reason that over time the return can end up being many multiples of 3 times the return.

This is the main reason that many market commentators cautioned novice retail traders about leveraged ETF’s. The other reason they were so hated was that the SEC thought that they would send volatility of the indices skyrocketing as hot money poured in and out of long and short leveraged funds. For this reason they placed moratorium on any new leveraged ETF’s which they are now considering lifting. The fears of hot money seemed to have been overblown as pointed out in this Fed paper. Leveraged ETF’s only consist of 1% of the ETF market and buyers don’t seem to stay in them for long (for the reasons just explained).

Once the hot money issue was quelled by the moratorium, commentators still scoffed at leveraged ETF’s due to the volatility drift and many claimed that due to this they would all go to $0 over time and the ETF’s would be liquidated. Indeed this happened with a few ETF’s that tried to track the VIX.

The other side of that daily compounding coin is on the upside though. What if I’m our example ABC moves up 1% three days in a row? That would move it’s price up to $13.31 a return of 33% but in the case of XYZ it would move up to $21.97 a return of 120%. This was the force at work over time in the case of Throwaway, a secular bull market saw more up days than down which moved higher in the up days than the down days moved lower.

Delving Deeper

We were just looking at equities so far, asset managers have created leveraged bond ETF’s as well. Think of a traditional diversified fund consisting of a mix of stocks and bonds. What if you were to mimick this portfolio but on a leveraged basis with ETF’s? This Seeking Alpha article by ADS Analytics, looked into just that possibility and found that various combinations of stock and bond leveraged ETF’s, rebalanced daily could produce risk adjusted returns well in excess of the S&P 500 over time.

Apart from doing it yourself, you could just outsource this strategy. PIMCO caught on to the phenomenon outlined in that Seeking Alpha article and has been offering a strategy that daily goes long on levered S&P 500 futures as well as long on levered long duration treasuries. The fund is PSLDX and has returned about 20% annually since 2010.

Naked Leveraged ETF’s Still Take the Cake

However the drawback to the strategy described by ADS Analytics and the PSLDX fund is that it isn’t tax efficient, a lot of those returns will be eaten up by being taxed as ordinary income due to the constant daily rebalancing required to maintain the strategy.

“Throwaway” and his long term leveraged net benefit from compounding upward as well as the tax benefits of holding the fund for the long term and hence only paying long term capital gains once he sells which will likely cut the tax bill in half and make it a one time payment.

This also got me wondering whether there were other leveraged ETF bets that did even better than the ETF’s picked by “Throwaway”. Showering the leveraged landscape I think I found the winner: the ProShares UltraPro QQQ (TQQQ) which returns triple the return of the Nasdaq.

Source: Google Finance

Above is just the performance over the past 5 years, since 2010 this ETF has risen 34 fold or about 42% annually over almost 10 years. There are only a few stocks I couldn’t find another stock that topped this one, not any of the FAANG stocks or ETF’s. It seems this was the trade of the decade that no one saw coming.

So Why Not Just Buy the Levered Funds Long Term

There has been a secular issue at play which maybe “Throwaway” didn’t foresee but benefited enormously from: an uptrend in the S&P with low volatility. With the exception of the last 2 months of last year, volatility has been lower than the long run average for the S&P over the last 10 years. Combine that with above average returns which we have seen and you have a recipe for leverage long bets to prosper.

The death spiral for these ETF’s where they would risk going to 0 would be in a high volatility stagnant or bear market scenario. In this case a huge drawdown or the volatility decay would risk hitting 0 and wiping out the entire ETF. Given that we shouldn’t expect to see returns like the past 10 years looking forward for the next 10, it’s safe to say these may not be your best bet from now until 2030.

The lesson learned however is that for those traders willing to experience eye watering volatility and believe a period of multi year positive gains in the index are ahead, may benefit from holding these securities. There is enormous risk involved, but as “Throwaway” showed, also enormous potential rewards if you are right.

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