Leveraged ETFs Can Be Key To Long-Term Portfolio Strategy

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Includes: SPXL, TQQQ, UPRO
by: ValueBull Investor

Summary

Leveraged ETFs are designed to use derivatives in addition to investor capital to produce 2x or 3x the daily return of their benchmark index.

Investors seeking long-term strategies that involve ETFs tied to large market indices can use leveraged ETFs to magnify their long-term investment return.

Although the strategy will be more volatile, if you believe in the long-term positive return prospects of an index, this strategy is an easy way to leverage.

Introduction

When looking at overall portfolio theory, we like to focus on active versus passive management. I tend to use active management with value investing methodologies to find undervalued companies, and the timeline for these investments could be anywhere from a few months to years, depending on a variety of factors. I usually hold these types of investments in non-registered accounts, and the turnover is typically quite high. Conversely, I use passive management for my registered accounts, and it involves using ETFs with a long time horizon. When I look at my registered account, I recognize that these holdings will typically be for 20+ years, and the ability to take on risk is quite high. Since I know that I have many years to recover from short-term volatility and fluctuations, the focus becomes on maximizing the long-term returns for the portfolio. Historically, the S&P 500 has averaged around 7.5% annually since 1950. If we use this as a baseline, we can assume that someone could potentially earn around 7.5% a year if they held their portfolio for a long time period. Knowing that I won't be buying and selling my ETFs based on short-term macro events or market volatility, it seems reasonable to use leveraged ETFs to maximize my returns and obtain higher than the 7.5%/year that the average S&P 500 would likely return to me.

How Leveraged ETFs Work

Leveraged ETFs are structured in a way to try and magnify a typical position gain (or loss) by using derivative instruments and debt, in addition to investor capital. For example, a 2x leveraged S&P 500 ETF would take every $1 of investor capital, borrow an additional $1, and use that $2 to invest in securities that would best mirror the S&P 500. Of course, there are management fees and other costs associated with this type of strategy, but overall, the funds have returned more than their benchmark index during up markets. Conversely, leveraged ETFs have also had greater losses than the standard benchmark during down markets, so there are absolutely risks associated with this strategy. The essence of using leveraged ETFs is that if you believe the index of your choosing is going to increase at a steady rate over the long run, leveraged ETFs will give you more growth. This strategy is similar to an individual using a margin account or borrowing funds to invest on their own; the difference is that you are not directly taking on the debt load yourself, and it is a simplified way to leverage your portfolio. Especially true if you are investing in these funds through a registered account - you may not always be able to leverage these types of accounts in traditional ways, so the best course of action would be to use a leveraged ETF to attempt to achieve magnified returns.

Return Potential

As I mentioned above, it is never guaranteed that an investment will return exactly 2 or 3 times the normal index when it comes to leveraged ETFs. And there are costs involved in these types of funds, so it is important to recognize that you will likely not receive that entire leverage. But you will very likely see returns, both positive and negative, that are higher than the normal index the ETF is pegged against. To illustrate this, I've take the example of the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO), which seeks to replicate 3x the investment results of the S&P 500, and graphed it against the S&P 500 index over several time periods. Other similar leveraged ETFs that I would recommend looking into include the Direxion Daily S&P 500 Bull 3x Shares ETF (NYSEARCA:SPXL) and the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ).

Year to date, the US market is flirting right around the 0% mark, so you can see below that the index has slightly outperformed UPRO. This makes complete sense considering the cost of the fund and the debt used to create a 3x leveraged position.

Next, I've pulled the last 3 months' results for the two in order to illustrate the risks associated with this type of fund. As the last 3 months have been quite a volatile period for the US market, you can see that the normal S&P 500 index has outperformed the UPRO fund quite clearly.

The 5-year chart is interesting, which shows my overall thesis on using leveraged ETFs. Although I am fully aware that the last 5 years have been one of the greatest bull markets in recent history, the point I want to illustrate is the ability of leveraged ETF funds to outperform their benchmark and earn returns that are close to 3x that of said benchmarks during periods of stock market appreciation. As I mentioned, the strategy I adopt is long-term buy, which tends to yield positive returns. This is especially true the longer you hold onto your investment and ignore the ups and downs that are typical in equity markets.

Strategy

As seen above, it's quite clear that using leveraged ETFs will increase the risk in your portfolio. They are meant to appreciate and depreciate in value based on the amount of leverage used, so some investors may not be comfortable with this strategy. For those who are looking at designing their portfolio to accumulate wealth and ride the equity markets over longer periods of time, I believe that using a leveraged ETF that mirrors a major market index, like the UPRO does, is a great opportunity. My recommended strategy would be to invest the same percentage in a leveraged ETF that you would in that general equity market otherwise, and then continue to diversify your portfolio to ensure you have the proper balance you need. This should be done with a licensed advisor who can gauge your overall risk tolerance and ensure you are comfortable with the volatility of leveraged ETFs and that your portfolio is balanced enough. Finally, when you are making additional contributions to your account, the power of dollar-cost averaging will benefit your leveraged ETF just as it does for any other investment, thus helping to propel you to your retirement goals more effectively.

Conclusion

Whenever I talk about leveraged ETFs, I always make sure I clearly explain the risks associated with this strategy. It's not for everyone, and these funds will require some research on your part in order to be comfortable enough with the investment. People who have failed to do so have sold these funds at a loss during volatile markets, because they failed to grasp the long-term nature of the strategy. In my opinion, if you believe a certain equity market index will perform at a certain level of growth over a long period of time, investing in a leveraged ETF is a great opportunity for you to get a higher rate of return than you would otherwise achieve.

Disclosure: I am/we are 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.

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