Tristan Yates

Foreign Investing and Diversification Lessons From Berkshire Hathaway

Good article. It looks to me that Buffet has a knack for picking large, growth, low-beta stocks that provide exceptional returns, which is really something when you consider that all of those factors are supposed to give you *lower* returns. And he is very well diversified - its not like he owns Coke and Pepsi. He picks a strong performer in an industry and holds it.

The Case Against Leveraged ETFs

I'll expand on the example. Today the closing futures price for the S&P 500 for June is 1518.80. But today's closing S&P price is 1512.75. The difference is 0.4%. In other words, the S&P 500 has to go up 0.4% by June closing, about 30 days away, just so you can break even. That's "how they get you", or in financial terms, how they build the cost of capital into the investment.

Let's say you have $100k to invest and you want to create a 2X S&P 500 index fund. You buy index futures on $200k worth of the index. Every month, you settle and buy more futures. A year later, the index has gone up 10%. Your gains are 20%, or $20,000 right? Not quite. The futures cost you 0.4% x 2 x $100,000 per month, or 4.8% of $200,000 = $9600 for the year. You end up with only $10,400 in gains.

But, because it only takes 5% margin to own a future, you were able to keep $90,000 worth of cash in your account all year earning interest. Invested at 5%, you get an extra $4,500. So your gains are $14,900, or about 15% of your investment. Which is what we'd expect given basic leverage formulas: $2 x 10% - $1 x 5% = 15%.

This is what I mean when I say money costs money. An interest rate is built into any financial derivative you buy, and any leveraged investor has to exceed that cost of capital before they start making money.

The Case Against Leveraged ETFs

Exactly - the financial derivatives they use has a built in cost of capital and the investment gains are reduced by exactly that amount.

For example, today the closing futures price for the S&P 500 for June is 1518.80. But today's S&P price is 1512.75. The difference represents a cost of interest, and if you calculate that cost on an annual basis, you'll get something close to 5%. Or the fund might just buy a swap - at settlement date they exchange the gains in the S&P 500 for the accumulated interest on a short-term bond that pays 5%. It all amounts to the same thing.

I agree that's its confusing, and I did struggle with that section for a while, trying to do a better job of explaining it.

Unique Diversification Benefits of Utilities

Great article. I wonder how insurance compares? That industry is also weather dependent and relatively inelastic.

ETF Options as Proxies -- Easier Said Than Done

Enjoyed the article. Some thoughts: Delta goes up as you hold the option, finally hitting 1.0 at expiry, so you get the full benefit of index ownership. Gamma rises too. Time value declines, slowly at first, and then more rapidly in the last few months. Dividends buy down the option cost.

It's a cheap loan basically, with dividends being applied to the interest costs. Leveraged investments have lots of interesting characteristics, such as having very high potential upsides, and the ability to go down to close to zero and them come back. They also have very high volatility. I'm a fan of leveraged investing, but wouldn't advocate it for everyone.

The 2X Direxion & Profunds have some long-term dangers related to their daily rebalancing. Check out the long term performance of some of the funds as compared to the underlying and there's some big underperformance.

Can ETF Options Offer Cheap Leverage to Reliably Boost Returns?

Hi Jordan. I like call options a lot because you don't get margin calls and can sidestep market declines. Also note that you wouldn't get dividends from the underlying- these are used to "buy down" the price of the option. That's partly why the carrying cost is low.

BTW This is called a "stock substitution" strategy, using derivatives in place of stocks, and it works well in low volatility environments. When the market's very chaotic, the price of those long options goes up and cuts into your profits.

Portfolio Rebalancing: The Ins and Outs

BTW Rebalancing is done primarily to decrease volatility, not improve returns. Imagine a thought experiment where you rebalance a diversified portfolio every day and don't pay any transaction costs to do so. You do that for a year and then check your portfolio. Some stocks have gone up, and you now have fewer shares of those stocks. Other stocks have gone down, and you have more shares of those stocks.

At the end of the year, it is possible that rebalancing helped your returns or hurt your returns. If one stock appreciated faster than the others, and your rebalancing forced you to sell shares in it and put them into poor performing stocks, then you probably did worse than if you had not rebalanced.

But when you look at your average daily returns thoughout the year, there will be tremendous consistency, especially if your stocks aren't very correlated. Every day you are perfectly diversified, and your portfolio moved just a little, either up or down. Your sharpe ratio will be lower than if you had simply bought and held the stocks based upon your starting allocations.

Note that rebalancing can also work very well if one of your assets is cash or bonds because it forces you to reinvest some of your gains in risky assets into risk-free assets. This can cut your volatility down tremendously.

Leveraged Growth/Value ETFs

Thanks for the link to our article. Check out this chart: SSO vs the S&P 500 Index. Since July the S&P Index is up 20% and the 2X fund is only up 30%, not 40%. That's a lag of about 7.5% over the period.

finance.yahoo.com/q/bc...;t=1y&l=off&am...

For the long term impact, look at the ProFunds UltraBull fund, which started in November 1997 as ULPIX, and has lost money in the past 9.5 years, even though the index is up +40% since then. You can find similar short-term and long-term underperformance in just about every leveraged fund/ETF.

Some of it could be because of expense ratios and interest, but I believe that most of it is due to the selling required when trying to maintain a constant leverage ratio in a falling market. Whenever I model a constant leverage portfolio that goes through any kind of downturn, it ends up selling off all of its shares in the downturn and can never come back in the next rally. But I'm open to competing theories/analysis.

Leveraged ETFs: A Value Destruction Trap?

Thanks for your comment. When you review the prospectus of one of these funds it mentions that a +10% daily rise in the fund followed by a -10% drop will result in a -4% total drop rather than -1% if you owned the index. That validates the share buying/selling computations that we used in the model.

I agree with you that they most likely do use a combination of index futures and T-bills, but when the futures go up, your leverage ratio will go down and when the futures go down, your leverage ratio will go back up, and you're still stuck rebalancing - either buying more futures or selling more futures. The effect is the same.

However, you're correct that we don't know the exact cost of debt. We just used the broker rate of options, which is about 5% right now, and yes, having money in T-bills could make that cheaper. But there is also high expense ratio too that we didn't model.

Anyway, check out the UOPIX chart also and see what you think.

Leveraged ETFs: A Value Destruction Trap?

A reader just let me know about an older ProShares mutual fund that tracked the NASDAQ with constant leverage.
The ticker is UOPIX, and the long-term chart is pretty scary and illustrates the constant leverage trap very well. And if you're thinking of profiting from the constant value trap by shorting the leveraged long, the chart shows that it would likely be successful eventually, but it that it could be a very wild ride.

As for David's brain teaser - is it better to be long the leveraged short or short the leveraged long? Well, you could go quadruple short if you buy the leveraged short on 50% margin. How does that sound?

36-Month ETF Correlations with Russell 3000

I'm not sure that 36 months is enough of a time frame to use for this research, especially given health care's underperformance and energy's outperformance during the period. If you use the Sector SPDRs, like XLF, XLV, etc, you have a more data to work with.

ETFs: Broadening or Perverting Index Investing?

Bogle's not talking about there being too many ETFs. He's talking about the idiocy of day trading something that was designed to be a buy and hold investment. And he's right as usual. Trading makes your broker richer and you poorer. Yet people are irrational and everyone thinks that they can beat the market for long periods of time, when that's just statistically impossible.

Tristan Yates
Index Roll: Indexing On Steroids