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Does It Make Sense To Buy-And-Hold Leveraged ETFs For The Long-Term?

Nov. 02, 2015 4:47 PM ETSPDR® S&P 500 ETF Trust (SPY)DDM, SSO, UPRO
Kyle Fishman profile picture
Kyle Fishman's Blog
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Summary

  • Leveraged ETFs (exchange traded funds) are a fairly new concept that allow traders to increase their risk/return ratio.
  • Most experts and advisers agree that leveraged ETFs are only designed as day-trading vehicles, and holding these long-term is highly discouraged.
  • The charts have produced results that disagree with the overwhelming consensus. Leveraged ETFs have produced surprisingly strong results in the face of heavy criticism.

Leveraged ETFs magnify an investor's risk/return ratio.

Warning Signs:

There have been countless articles published that warn long-term investors to stay away from leveraged ETFs. This is because they have daily rebalancing that causes decay over time.

For instance, ProShares UltraPro S&P 500 (SSO), a 2X fund that tracks the S & P 500 (SPY), may not necessarily produce 2X the return of the S & P 500 over the long-term. SSO may even go down in value while SPY makes gains, as demonstrated in the chart below.

SSO was originally established in mid-2006, and obviously it suffered effects from the infamous broad-market crash in 2008. In mid-2012, the chart shows SPY up roughly 15% while SSO is down nearly 20%. This chart appears to support all of those warnings about holding leveraged funds from the long-term.

It's not what it seems:

If you take a look at the chart in broader context in a more recent and updated version, it will look more like this:

The fact is, from its inception in 2006 through present day, SSO outperformed SPY 84% to 66%. It took time to recover from the 2008 crash but it eventually proved to be a positive long-term investment.

The warnings were correct about SSO not producing 2X SPY. The returns were not double. However, SSO still outperformed SPY; meaning it can be suitable for long-term investors.

When you look at the chart for ProShares Ultra Dow30 (DDM) which tracks 2X the Dow Jones Industrial Average, it's the same result: DDM outperformed DIA from its inception in mid-2006 through present day.

The leveraged ETFs have proved the experts wrong:

They have withstood the test of time and volatility. These funds recovered from the infamous 2008 crash. These funds withstood a volatile year in 2011 and another volatile year in 2015.

Performance should have been worse during Abnormal Circumstances:

On an additional point; the 2008 crash was a highly unusual circumstance. A 50% crash may happen again, but it's a very rare occurrence. Warren Buffett once said, "Humans will behave in crazy ways, both on the upside and the downside in the next 50 years. It's very unlikely they do it in the next few years because after something like 2008, once they get out of the emergency room, they're a little more careful for a while."

If volatility is bad for leveraged ETFs.....well, 2008 was the most volatile year in modern history! If these funds can recover from that, then they will perform just fine during normalized conditions over the long-term.

To illustrate what normalized conditions may look like; here is a chart of SSO tracking 2X S & P 500, from 2011 to present day:

SPY returned a little over 55%. SSO (2X SPY) returned a lot more; 160%. 2011 and 2015 experienced a great deal of volatility; it was not a pure bull market. Volatility is known to cause decay on leveraged ETFs. Despite the volatility, SSO performed quite well.

During normalized conditions, when the market is at a historically average level of volatility, I suspect these funds will come a lot closer to producing 2X-returns of the index they track.

But even when conditions are abnormal, they have still proven to produce positive results.

3X Leverage

The leveraged ETF that tracks 3X SPY (UPRO) has also produced very positive returns during historically normal periods of volatility as demonstrated in the chart below where UPRO returned more than triple the index it tracks:

Conclusion:

The warnings are over-blown. Leveraged ETFs can be suitable buy-and-hold investments for the long-term.

An alternative strategy:

While leveraged ETFs can be good buy-and-hold investments over the long-term; perhaps a smarter and safer strategy would be to 'buy-and-rebalance,' meaning; increase leverage while the market is on a dip. As the market goes higher; decrease leverage. History says it pays to buy on dips.

Analyst's Disclosure: I am/we are long SPY, SSO, DDM, UPRO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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