How To Implement An Effective Rebalancing Plan
With all the media coverage of the leveraged ETF controversy that has been brewing over the past several months, it is becoming increasingly difficult to separate the facts from the fiction. As firm after firm bans the use of these funds, a growing number of investors are unable to utilize leveraged ETFs. For those who do retain the ability to use these funds, the horror stories of return erosion and flood of lawsuits might cause even the most sophisticated investors to steer clear. But while the dangers of leveraged ETFs (if used by those who fail to understand their risk profile) are very real, the potential upsides can be equally spectacular.
Of the countless misconceptions about leveraged ETFs, perhaps the most damaging is the notion that the returns on these products become wildly unpredictable when held over multiple trading sessions, due to the daily compounding of returns. While this can occur in certain markets, investors can implement a fairly simple process to ensure that leveraged funds will track the target multiple of their benchmark over longer time periods.
Most traders move in and out of leveraged ETF positions within a single trading session, as the objectives that they use these funds to accomplish are short-term in nature. But an increasing number of advisors have begun using leveraged ETFs over extended time periods to generate amplified returns on trends that may not play out in a single trading session. Since leveraged ETFs compound daily returns, returns over multiple trading sessions can often result in unpredictable returns, particularly in seesawing markets. But by using a relatively simple rebalancing plan, advisors can increase the likelihood that returns on leveraged ETFs will closely correspond to an intended multiple of the related index.
Leveraged ETFs 101
Leveraged ETFs use complex financial instruments, such as swaps and futures, to magnify the daily returns on a benchmark. For example, the ProShares Ultra S&P 500 (SSO) seeks to provide daily returns corresponding to 200% of the daily return on the S&P 500 Index. If the S&P 500 rises 1% for a single trading session, SSO should be expected to rise by about 2% (and it often does, as demonstrated in this feature).
Because leveraged ETFs seek to amplify daily returns, these funds reset their exposure on a daily basis. It is for this reason that when held for multiple trading sessions, the return on the leveraged ETF may deviate from the multiple of the return on the underlying index, particularly in oscillating markets. A leveraged ETF increases its exposure as its price rises and decreases its exposure as its price falls, leading to potentially undesirable results in a volatile, non-trending market.
Not Rocket Science
Many analysts and journalists convey leveraged ETFs as a mysterious black box that implements strategies beyond the grasp of most investors to generate erratic, unpredictable returns. In reality, the concept behind leveraged ETFs is easy to understand, and the consistency with which the funds achieve their stated objectives is rather impressive. Leveraged ETFs reset their market exposure on a daily basis, meaning that they are generally intended to be short term investments.
How To Optimize Leveraged ETF Returns
Some coverage on leveraged ETFs is correct: the effects on a portfolio in certain markets can be devastating if used incorrectly. But if used correctly, these ETFs can be powerful tools that can allow advisors to “double down” (or triple down) on anticipated movements in a benchmark. Advisors shouldn’t necessarily be scared of investing in leveraged ETFs for multiple sessions, but they should do so only if prepared to monitor the performance closely and potentially implement a rebalancing plan.
Leveraged ETFs are appropriate only for a relatively exclusive universe of investors for two primary reasons. The first is that since these funds are designed to amplify returns, they are likely to significantly increase the volatility of any portfolio that includes them, which may be inappropriate for risk-averse investors. Second, these ETFs require daily monitoring, since their performance over multiple trading sessions depends not only on the change in the related benchmark, but on the path of that index during the relevant period. Investors without the time or resources to monitor leveraged ETF investments on a daily basis should stay away from these products. The “set it and forget it” approach may work for long-term buy-and-holding, but it won’t work with leveraged investing.
As discussed above, leveraged ETFs operate with daily returns in mind, so bull funds must increase their exposure as the underlying index rises and decrease exposure as the markets fall. As a result, in seesawing markets leveraged funds will tend to return less than the multiple on the underlying benchmark when held for multiple periods, because a losing session will come on the heels of an increase in exposure and vice versa.
Consider this hypothetical example:
|Period||Index Value||Daily Index Return||3x Leveraged ETF Price||Leveraged ETF Return|
As shown above, the market rises 10% over a 10-day period, but a hypothetical 3x leveraged ETF tracking the benchmark would only rise 22.1%, or about 2.2x the return on the index. Depending on the level of volatility and period in question, returns on leveraged funds can deviate even further from the multiple on the underlying benchmark (note that on Day 6 the leveraged ETF had actually generated a negative return when the underlying index is up).
Again, since leveraged ETFs operate with daily returns in mind, their performance over multiple trading sessions can digress from the multiple on the underlying benchmark.
Rebalancing Is The Key
Contrary to popular belief, leveraged ETFs can be used to generate amplified returns over an extended period of time. But they can’t do it alone. (i.e., a “set it and forget it” approach won’t do the trick.) By implementing relatively simple rebalancing strategies, leveraged ETF investors can more closely approximate an amplified return on leveraged ETFs over multiple trading sessions.
By their very nature, bull leveraged ETFs increase exposure following increases in the benchmark index and decrease exposure when the index declines (as shown above). In order to achieve leveraged results beyond the short term, however, investors want to do the exact opposite. As the underlying index increases, advisors should reduce exposure by selling shares. As the index declines, advisors should increase exposure by purchasing additional shares. Consider the implementation of such a strategy assuming the same 10-day period:
|Beginning ETF Investment||Daily Index Return||Ending ETF Value||Daily Gain (Loss)||Cash Withdrawal (Investment)||Ending ETF Investment|
|Total Cash Flows||$20.00|
After the leveraged ETF rises on day 1, investors could reduce the position in the fund by pulling out two-thirds of the daily gain. After a decline on day 2, an additional cash infusion (again, equal to two-thirds of the daily loss) is required.
The strategy summarized above rebalances on a daily basis such that the ending exposure in the leveraged ETF is equal to the value of the index on that day. (Note that the far right column on the above table is equal to the second column on the first table.) After 10 days of volatile market returns, the investment in the leveraged ETF has increased from $100 to $110, and the advisor has taken a net amount of $20 from the investment, summing to a total return of $30, exactly equal to 3x the return on the index over the period.
The obvious oversight in this example is fees and expenses that would be incurred by such frequent rebalancing. This example is extreme in the sense that it implements a daily rebalancing strategy. The less frequent the rebalancing, the greater the tracking error and the lower the fees. In reality, it may be more sensible to set a “trigger point” at which point leveraged ETFs should be rebalanced (i.e., a deviation between the returns on the index and the return on the ETF). Unfortunately, there is no way around a trade-off between expenses and tracking accuracy when dealing with leveraged ETFs.
Disclosure: No positions at time of writing.