Imagine little John Doe being born in 1950. His mom knitted booties for him. His dad - unusual for the times - changed his first diaper. When the happy couple came home from the hospital, they sat down and decided to do something for the newborn, to plan his retirement right there and then.
Now, this is not how most kids would start their life, but let's play on, dear reader, and assign unusual clarity of thought and purpose to Mr. and Ms. Doe. How do you think they could best serve their kid?
Now, while we are at it, let's also assume that someone, somewhere waved a magic wand, and made available to the Does something called Exchange Traded Funds, especially leveraged ones. Let's also assume that a new index got created that year, called the S&P 500 (NYSEARCA:SPY). Finally, let's also assume that by a miracle, an unique product called the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO) was available the same day.
ProShares UltraPro S&P500 seeks daily investment results, before fees and expenses, that correspond to triple (300%) the daily performance of the S&P 500®.
Mr. and Ms. Doe by sheer coincidence happened to be right in the median of household incomes for 1950. Their income for the year was ~$3,500. They decided to put 10% of that, or $350 into the new UPRO product (this is equivalent to about $2,500 in 2013 adjusted for inflation). They decided to keep it hidden from Little Johnny for 63 years, a true long term buy and hold. When John became 63, he was made aware of this little gift his parents had stashed away for him. How much money do you think John would have?
Before you answer the question, let's first see how the S&P500 index has done since debut in 1950. According to Yahoo Finance, the S&P500 started in January, 1950 at $16.66, and ended on February, 2013 at 1517.93. $350 invested in the S&P500 in 1950 would result in about $32,000 in 2013. Little Johnny would be somewhat happy, but certainly not able to retire with that money.
Now, let's see what would have happened if Mr. and Ms. Doe put that $350 in the UPRO product. I simulated the UPRO by downloading the daily returns for the S&P500 index over the past 63 years and then simulating 3x daily returns, cumulative. This exercise shows that Little Johnny would have about $2.4 Million in his account. I dare say he would be very pleased indeed.
This is the power of leveraged ETFs.
However, everyone loves to hate leveraged ETFs. Some say, take a pass. Others say, stay away. They are supposed to be day trading vehicles only. They are supposed to erode fast from volatility, and perform far worse than the underlying vehicle on which they are built. This is true, but only if there is a lot of volatility and sideways movement of the underlying.
Let's imagine an underlying that has 0 drift (i.e., the average daily return is 0%). This underlying goes up 10% one day, 10% down the next, and repeats this for 20 days. The volatility is 10%, but the average daily return is 0%.
After 20 days of this up and down journey, the underlying will be at $90.4. A 3x leveraged ETF on it, bull or bear, however, will at $38.9. So, even though the underlying has dropped less than 10%, the 3x leveraged bullish ETF has dropped more than 60%. It is even worse for the leveraged bearish ETF, which should have been up, but instead is down 60%+ as well. The below graph shows how the three will behave.
So, why is UPRO behaving so well when simulated over the past 63 years? The answer, of course, is very simple. The underlying, the S&P500, has a significant positive drift instead of the 0 drift in the above example. Also the S&P500, by virtue of being a broad market based index, essentially has low volatility, far, far lower than the 10% assumed in the example.
This is what people who love to hate leveraged ETFs miss. They create doomsday scenarios for no drift and high volatility underlyings, which do exist in real life for commodities like gold, but not for broad stock market indices like the S&P500. Leveraged ETFs on such indices do very, very well indeed. They do have large max drawdowns, but if truly held for long periods of time they provide spectacular returns. The average annual return of the simulated UPRO, for example, is ~16%, while the return of the underlying S&P500 is ~7%. (If 2x leverage was used then the average annual return would be ~13%.)
The large max drawdown is a concern for professional investors, who need to make ends meet every day. It should not in any way be an issue for a true long term buy and holder. This is where individual investors have an edge over professional investors. They can truly ignore market fluctuations and focus on the long term. Professionals can't. They need that million-dollar bonus at the end of each year, and hence have to watch the market volatility each and every day.
Watching the market volatility each and every day, of course, is the worst way to build a retirement portfolio.
In summary, there is no good reason to hate leveraged ETFs on broad indices. These do not have the low drift high volatility characteristics commonly associated with commodities, and hence erode little. However, they provide exceptional returns over really long periods, in this example 63 years. I hope this puts and end to the debate whether leveraged ETFs are suitable for individual retirement portfolios, as long as the time horizon is sufficiently long (I would say 30 years+).
I do hold UPRO in my retirement account.
Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice. I am merely stating what I personally plan to do for my own portfolio.
Disclosure: I am long 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.