Anyone worried that America has become a land of excess and impulse should relax: the country still doesn’t have quadruple-leveraged exchange-traded funds (ETFs).
The first application to list such a product came more than a year ago in September 2016, from ETF Managers Group. However, the ForceShares Daily 4X US Market Futures Long fund is still not available to investors.
The Securities and Exchange Commission initially approved the fund – which strictly speaking would be a commodity pool listed on NYSE Arca rather than a conventional ETF – back in May this year, but swiftly put the brakes on. The fund is now pending further review. In the meantime, ProShares has also sought permission for its own QuadPro quadruple-leveraged fund.
There are plenty of valid concerns about leveraged ETFs in general: from their ‘daily reset’ mechanism that often serves to exacerbate losses, to counterparty risks and the more general notion that they are designed for short-term speculators rather than long-term investors.
However, it is also possible to set out a reasonably justified case in favor of the quadruple-leveraged funds: for one, they are regulated and are therefore safer than other means of getting exposure to the leveraged market. What’s more, triple-leveraged funds for riskier assets such as gold miners are already available on the market, and their quadruple-leveraged counterparts would generally be cheaper than buying a double-leveraged ETF on margin, which many brokers allow.
To these claims can now be added a more contentious and counterintuitive suggestion: that leveraged ETFs can make portfolios
Some investors doubtless already view inverse or short ETFs as a form of portfolio insurance, and accept that these products will lose money most of the time but should pay off in a crash.
However, the novel perspective on leveraged long ETFs comes from Jeffrey George and William Trainor of East Tennessee State University. They argue that by using leveraged ETFs, investors can gain the same exposure to risk assets as they would otherwise have, while also allocating a greater proportion of their portfolio to risk-free assets.
For example, in what is known as a constant proportionate portfolio insurance approach, 50% of a portfolio may be invested in equities. If a double-leveraged ETF is employed, however, only 25% needs to be allocated to equities for the same exposure; 75% of the portfolio can then be devoted to earning the risk-free rate. A triple-leveraged ETF enables the risk weighting to fall even further to just 16.67% for that same 50% equity exposure.
Safety in numbers
George and Trainor examined whether this worked in practice, using the S&P 500 for the equity allocation and one-year Treasuries as the risk-free asset.
Over the very long term, it did. Between January 1947 and December 2016, a 50/50 portfolio of the S&P 500 and one-year Treasuries returned an annual average of 10.13%, with a maximum annual drawdown of 8.65% and a Sharpe ratio of 0.51.
As would be expected, this underperformed a purely equity portfolio in total-return terms: the S&P 500 delivered an annualized 12.53% for the period, but came with a significantly higher maximum annual drawdown of 36.65%.
When the 50% allocation to equities was cut to a 25% weighting through a double-leveraged tracker, the average annual return climbed to 10.6%. For proportionately smaller positions in triple- and quadruple-leveraged funds, it rose even further to 11.15% and 11.48% respectively. In each case the maximum drawdown remained just above 8.6%, even though the underlying leveraged funds lost a maximum of between 66.82% and 94.55% over this period, while the Sharpe ratios increased to 0.53, 0.56, and 0.57.
Encouraging as that may seem, that longer-term performance was of course predicated on the risk-free rate being higher than zero. When George and Trainor narrowed their focus to between 2007 and 2016, a period marked by squeezed interest rates and record low bond yields, they found that using a double-leveraged fund lowered the portfolio’s average annual return by 30 basis points relative to the simple 50/50 mandate.
‘There is simply no additional return from having a greater percentage of wealth in the risk-free rate to compensate up for leveraged ETFs’ higher expenses and leverage decay [the tendency of the daily reset to erode returns],’ George and Trainor observed. When they ran the numbers, they determined that risk-free yields needed to be 3% or more for constant proportionate portfolio insurance using leveraged funds to prove effective.
Even with the Federal Reserve in a hiking cycle, that time may be some way off. When it comes, though, this technique may prove its worth.
‘This study demonstrates that leveraged ETFs, even a four-times leveraged ETF if it becomes available, can be used to enhance return and reduce risk within the right context,’ George and Trainor concluded.