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leveraged etfs under performing in a bull market. Why?


stahleyp
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So I was looking at different levered etfs (upro vs spy) and the results are what one  (roughly) expects. UPRO is 3x  (daily) returns so over the past 10 years or so it averaged about 38% vs a little less than 15% for SPY.

 

If you look at EFA vs  DZK over the roughly 11 years, DZK comes out at 6.69% vs 7.22% for EFA. So it's been a bull market and the 3x etf actually underperformed (with substainlly higher drawdowns).

 

The expense ratios on DZK and UPRO aren't huge (about .2% difference) but I was surprised at the results.

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So I was looking at different levered etfs (upro vs spy) and the results are what one  (roughly) expects. UPRO is 3x  (daily) returns so over the past 10 years or so it averaged about 38% vs a little less than 15% for SPY.

 

If you look at EFA vs  DZK over the roughly 11 years, DZK comes out at 6.69% vs 7.22% for EFA. So it's been a bull market and the 3x etf actually underperformed (with substainlly higher drawdowns).

 

The expense ratios on DZK and UPRO aren't huge (about .2% difference) but I was surprised at the results.

 

These 3x are only good for holding short term. You shouldn't consider holding them for 10 years.

The reason is because they adjust the leverage ratio daily to keep it 3x.

For example, if you enter a period of choppy up down market.

Let's give a more extreme example to make it clearer: it is up 10% first day, down 10% second day, up 10, down 10.......

Then at the end of first day, it has to increase the leverage by 10% to keep it 3x. So as soon as it increased the leverage by 10%, the market is down 10% next day, so at the end of next day, it has to decrease leverage by 10%, which is also the exact wrong time as it is up 10% again the 3rd day....

So if you hold SPY unleveraged, after 4 days, you are break even, but if you hold 3x leverage, after 4 days, you have 130% * 70% * 130% * 70% = 0.82, so you just lost 18% of your money in 4 days.

 

Of course if the market is in an up streak, then you'll do extremely well, but up streaks are very rare and usually short even in greatest bull markets.

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thanks for the explanation, muscle. This might sound silly but if you bought and sold it everyday (sell at close and rebuy at open), would you then get the 3x? I'm assuming the adjustments are made at night. Obviously, it wouldn't work out perfectly since the market doesn't reopen at the same level but I wonder if it would work out well enough.

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Guest cherzeca

muscleman explains this well above, but 3x etfs can perform very well in good markets.  compare FAS (96% gain over 1 year) to XLF (26% gain over 1 year).  just have to have conviction going into it and figure out when to pull the ripcord

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I was thinking of having a strategy of something like 1/3 UPRO and 2/3 BND. If another 2008 happens, you'll limit your downside to less than 33% on the stock side while still getting the upside of 100% stock. I guess the issues becomes how choppy the returns are and the bond market also dropping.

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Guest cherzeca

I was thinking of having a strategy of something like 1/3 UPRO and 2/3 BND. If another 2008 happens, you'll limit your downside to less than 33% on the stock side while still getting the upside of 100% stock. I guess the issues becomes how choppy the returns are and the bond market also dropping.

 

it is an interesting idea, but I confess I dont understand credit markets anymore, since when sh*t hits fan, equities go south as expected, but everyone flocks to FI, yields go down and you suffer principal impairment. without having researched it, I would be more inclined to hedge with GLD.  others may disagree

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I was thinking of having a strategy of something like 1/3 UPRO and 2/3 BND. If another 2008 happens, you'll limit your downside to less than 33% on the stock side while still getting the upside of 100% stock. I guess the issues becomes how choppy the returns are and the bond market also dropping.

if you want to take a long-term levered position leaps are the better way to go.

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thanks for the explanation, muscle. This might sound silly but if you bought and sold it everyday (sell at close and rebuy at open), would you then get the 3x? I'm assuming the adjustments are made at night. Obviously, it wouldn't work out perfectly since the market doesn't reopen at the same level but I wonder if it would work out well enough.

 

Are you asking whether you would then get 3x on a yearly or multiple year basis?  If so, no.  You get the same thing 3x the daily move.  All you miss out on is the change from the close to the open.

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Guest cherzeca

One idea I keep thinking but never got time to try on the historical data is, to dollar cost average a 3X index. Has anyone done the analysis, and care to share the finding?

 

great idea.  but the 3x etf compounds daily in essence. isn't that dollar/cost averaging built in?

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thanks for the explanation, muscle. This might sound silly but if you bought and sold it everyday (sell at close and rebuy at open), would you then get the 3x? I'm assuming the adjustments are made at night. Obviously, it wouldn't work out perfectly since the market doesn't reopen at the same level but I wonder if it would work out well enough.

I think they can only trade near the end of the market close to adjust the leverage to maintain 3X. The name is 3X daily which tells you that they adjust daily.

The tax consequences is insane. I would not consider it unless in my tax deferred account.

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yeah Stevie and muscle, I was wondering about trying to get the annual 3x by doing that so thanks.

 

Also, how are the taxes different on this? Like, if you buy UPRO and hold for a year, it's not a regular long term gain?

No. Buying ETF is not much different from buying a mutual fund. The index ETFs are different because they don't actively trade, though when they do, you still get some additional forms to fill.

For active ETFs, it is just like investing in an active mutual fund.

Think about it this way: If you can buy an active ETF and enjoy long term gain, then why don't you launch an ETF yourself and put all of your money into it, and actively trade it yourself, and enjoy long term gain? That's an obvious tax loophole if it works. It doesn't work that way.

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yeah Stevie and muscle, I was wondering about trying to get the annual 3x by doing that so thanks.

 

Also, how are the taxes different on this? Like, if you buy UPRO and hold for a year, it's not a regular long term gain?

No. Buying ETF is not much different from buying a mutual fund. The index ETFs are different because they don't actively trade, though when they do, you still get some additional forms to fill.

For active ETFs, it is just like investing in an active mutual fund.

Think about it this way: If you can buy an active ETF and enjoy long term gain, then why don't you launch an ETF yourself and put all of your money into it, and actively trade it yourself, and enjoy long term gain? That's an obvious tax loophole if it works. It doesn't work that way.

 

 

good points. I had assumed that these would be taxed like ordinary index etfs but I can see why that's not the case now. Thanks!

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wow the results for the emerging markets 3x are horrendous.

 

For roughly 10 years, EEM averaged 7.64% vs ECD (3x) 2.39%.

 

Max drawdown of EDC was 87.48% vs 32.71% for EEM. crazy!

 

Now, if you do the 33% EDC and 67% EMB (bonds) that combination returned 9.37% (with a slighly lower max drawdown).

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