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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…?

Source: Leveraged ETFs: Not for Long Term Investors