Seeking Alpha

Do Investors Need To Worry About Beta Slippage In Leveraged Funds?

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Includes: QQQ, SPXU, SPY, TQQQ, TVIX, ULPIX, UPRO, UVXY, VOO
by: Jonathan Cooper
Summary

Leveraged funds are highly volatile, with 90% draw-downs and 16+ year recoveries.

But leveraged funds can outperform their leverage in markets with clear direction and low volatility.

Over the past five years, the stock market has been closer to the latter than the former, but VIX has not been suitable for leveraged funds.

Leveraged funds can be a valuable long-term holding in a diversified portfolio and the risks of beta slippage are often overstated.

Leveraged ETFs are very dangerous. We all know that, right?

On ETFdb, leveraged ETFs are discussed as if they are toxic. The headlines say things like, "Be Wary of Holding Overnight," "Active Traders: Use With Caution," and "Long-Term Investors: Stay Away." It sounds like a minefield; who would venture into that?

From these headlines, I would assume that leveraged ETFs are dangerous and should be avoided by all investors. To test this theory, I decided to take a deeper look.

Beta Slippage Basics: Crushed By An Oscillating Index

One of the most commonly-cited dangers of leveraged ETFs is beta slippage.

In general, leveraged ETFs seek to match the daily performance of a leveraged portfolio. For example, UPRO is a 3x leveraged S&P 500 (SPY, VOO) ETF. This means that if the S&P 500 is up 1% in a day, UPRO should be up 3%. If the S&P 500 is down in a day, UPRO should be down 3%.

For single-day performance, the performance of a leveraged ETF should match investor expectations. Investors will gain and lose as much as they expect.

This is not the case for performance over multiple days, however.

Imagine that we invest in an index that begins at 100. Suppose it gains 10 points one day, and loses 10 points the next, and this continues for fifty days. After fifty days, the index is still at 100. If we put in $100, we have $100.

Now let's invest in the same index using 3x leveraged funds, both long and short.

Fig. 1: Performance of leveraged funds in an oscillating market

This is a typical leveraged fund example. An oscillating, directionless index leads to high levels of decay. Daily leveraged funds are a terrible long-term holding in such an index. Decay is inevitable over a long timeline, and will crush investors in such a fund.

Decay will be worse in higher-leveraged ETFs than lower in this market: 1.5x will perform better in this market than 2x, and 2x will perform better than 3x. But all will perform worse than the underlying index.

The stock market does not behave in this manner. But perhaps other indices do.

Chart^VIX data by YCharts

This is a five-year chart of the CBOE S&P 500 volatility index (VIX). This is a measure of the volatility of the stock market, based on implied volatility in S&P 500 options. Volatility is currently below its five-year average, but tends to oscillate around a central point with relatively insignificant upward or downward trends.

Based on Figure 1, I would expect leveraged funds to have performed poorly over this five-year period.

There are no 3x leveraged ETFs for VIX, thankfully. However, there are 2x leveraged ETFs: ProShares Ultra VIX Short-Term Futures (UVXY; 2x long VIX) and VelocityShares Daily 2x VIX Short Term ETN (TVIX; 2x short VIX).

ChartUVXY data by YCharts

"Performed poorly" may be an understatement. In percentage terms, both UVXY and TVIX have lost 100.0% (rounded to the nearest tenth) in the last five years.

Note that I am not claiming that 100% of this decline is due to decay (management fees, roll yield, tracking errors, and other factors may be at work). However, decay is a factor. I am, however, claiming that both of these funds are poor long-term investments, just like ETFdb warned us about.

But not all leveraged funds.

Why Oscillation Hurts Leveraged Funds

Why does oscillation hurt leveraged funds? This is counterintuitive to many investors.

If I walked into my local brokerage and used my $100 plus a borrowed $200 to purchase $300 of stocks, that holding would perform as we might expect. It would be 3x leveraged for the life of my holding. If the index jumped from 100 to 110, I would have $330. If the index dropped back to 100 from 110, I would be back at $300.

However, these predictable results are due to changing leverage. After the first day in my example, my effective leverage is less than 3x: I have borrowed $200, but have $130 of my own money in the market.

In contrast, a leveraged fund will be 3x leveraged at the beginning of every day. In my example, I would have $130 in the market. To be more like a leveraged fund, I would need to then borrow $60 more, to have $260 borrowed at the beginning of the second day, resulting in $390 of exposure. When the market falls from 110 to 100 (-9.1%) the next day, I would lose $35.45, leaving me with $130 - $35.45 = $94.55.

This is how a leveraged fund works: It is re-leveraged to 3x daily, resulting in outcomes that will vary from the overall performance of the market, since overall exposure to the market will vary day-to-day.

This means that after every winning day, we borrow more money to re-leverage to 3x. And after every losing day, we return some borrowed money to keep leverage down to 3x. In an oscillating example, this means we borrow money before every losing day, and we reduce our exposure to the market just before every winning day.

It's no mystery why that doesn't work out well.

Beta Slippage Can Help, Too

But beta slippage isn't always a losing bet. In Figure 1, we borrowed more before every loss and reduced our exposure prior to every win.

Let's imagine a few other markets.

Scenario 2: What about a market that begins at 100, and gains 1 point every day for 50 days, ending at 150? That is, an extremely steady, upward-trending market.

In that market, we should expect a 3x leveraged long fund to do extremely well, and a 3x leveraged short fund to do very poorly. Overall, the market gains 49%. But how much do the leveraged funds gain or lose?

Fig. 2: Leveraged funds in a steadily upward market

In this market, both leveraged funds perform better than a naive expectation. The market gains $50, so one might expect the 3x leveraged long fund to gain $150. Instead, it gains $234 thanks to compounding effects. Meanwhile, the 3x short fund could not reasonably expected to lose $150, since it did not invest $150 to begin with. It loses $71, ending at $29.

Unlike the market in Figure 1, here both leveraged funds make decisions that help their performance. The long fund increases its exposure to the market every day, which is helpful because the market then gains the next day each time. The short fund decreases its exposure to the market every day, which is helpful because it would have lost more if it has not decreased its exposure. These compounding effects help the leveraged funds in markets which offer significant directional performance.

Beta slippage is a two-way street. It can result in gains or losses, depending on the performance of the market.

Beta slippage is also path-dependent. In the previous example, the market ended at 150 after fifty days. But other ways for the market to end at 150 result in much different outcomes.

Fig. 3: Unsteady-But-Upward Market and Leveraged Funds

As shown, the market can also end up at 150 by gaining ten each odd day, and losing 8 each even day. As in Figure 1, results whose signs differ day-to-day are terrible for leveraged funds. Here, the 3x leveraged long fund is up only $15, while the 3x leveraged short fund is down $97.

In summary, beta slippage can result in either gains or losses over the underlying index over a longer period. These results will vary based on the path taken to get to the final market value, and not just on the final market value.

But What About The Real World?

Performance in hypothetical markets helps to explain why leveraged funds perform differently than a naive expectation. But we don't invest in hypothetical markets.

Instead, we should look at how leveraged funds do in the real world, but keeping in mind the drivers of fund prices. For a leveraged fund to succeed, we need a market that is rising (or falling, if short) long-term and with volatility that is low relative to yields.

To find such a market, let's look at the Sharpe ratio (excess returns divided by volatility) of various indices, to see if they might perform well with leverage. A higher Sharpe ratio is better.

Chart^SPX data by YCharts

Based on these Sharpe ratios, I would expect leveraged investments in the S&P 500 and the Nasdaq to have performed well over the past five years. These high Sharpe ratios could help leveraged funds outperform even 3x their indices.

ChartVOO Total Return Price data by YCharts
ChartQQQ Total Return Price data by YCharts

Over the past five years, leveraged funds (UPRO, TQQQ) have outperformed their indices (VOO, QQQ) for both the S&P 500 and the Nasdaq. This out-performance is more than their 3x leverage, in part due to compounding effects, as described above.

In short, over the past five years, UPRO and TQQQ have been great investments for long-term investors. During a bull market, their performance has far outstripped the underlying index.

What Does This Mean?

I am not suggesting blindly purchasing leveraged funds. However, the fear of leveraged funds is misplaced, in my view. Leveraged funds can offer a valuable addition to an investor's portfolio, when used correctly. I am likely to add leveraged funds to my portfolio, when tax restrictions (due to moving to Canada and capital gains tax interactions) are no longer applicable.

But these are still tools that should be used with caution.

Be wary of leveraged funds in volatile, sideways markets. I would not recommend holding leveraged funds long-term in markets without significant directional characteristics relative to their short-term volatility. Specifically, long-term investments in VIX-based leveraged funds (UVXY, TVIX) will be a poor idea.

ChartSPXU data by YCharts

Be careful of short leveraged funds. In general, the market has historically moved upwards. If the market did not move upwards, it is unlikely that any of us would be on this site, since our money would be better invested elsewhere or kept under the bed. Short funds can and do make a profit, but I would be skeptical of any strategy that holds short funds long-term. Even if you're bearish about the economy, I would avoid holding ProShares UltraPro Short S&P 500 (SPXU) long-term, for example.

Past results don't predict future outcomes. Over the last five years, UPRO and TQQQ have performed well, both in absolute terms and even relative to 3x their underlying indices. But that does not mean their performance in the future will fare similarly. This has been a period of very low volatility (see the VIX index above), which favors leveraged funds. This has also been a bull market. Investing in long leveraged funds is a bet that both of those conditions will continue. This bet could lose with either higher volatility or an economic slowdown.

ChartULPIX Total Return Price data by YCharts

Leveraged funds are risky; invest only what you can afford to lose. The stock market is risky. Leveraged funds are even more risky. ProFunds UltraBull ProFund (ULPIX; 2x leveraged S&P 500 mutual fund) fell nearly 90% between 2000 and 2009. It did not recover from the dot-com crash until 2016. These are not investments for the faint of heart, and should make up only a small portion of a diversified portfolio.

Future Work

I continue to look at leveraged funds. I'd like to do more research before I choose whether to include these funds in my portfolio.

Specifically, I plan to look at how hypothetical leveraged funds (including management fees) would have performed in past market conditions prior to the actual availability of leveraged funds.

I would also like to consider which types of asset classes might perform best with leveraged funds, such as bonds, gold, and other commodities. I am also interested to see how other strategies, such as merger arbitrage, might fair in a leveraged fund. Credit Suisse (NYSE:CS) once offered such a leveraged fund, although it is no longer offered.

I will also continue to look at diversified portfolios which include leveraged funds, and back-test those strategies. I am especially interested in portfolios which may help reduce market volatility but still offer strong returns. Leveraged funds can be a part of such a strategy, since they offer exceptional returns in good markets. When combined (in small quantities) with "safer" assets, such a portfolio can offer strong portfolio with lower draw-downs.

Conclusion

I do not think investors should be reflexively afraid or dismissive of leveraged funds. These funds can offer value in their small exposure to the market and potential for oversized returns. This can be valuable in developing a portfolio.

Despite that, leveraged funds are very volatile and should be used only by experienced investors aware of their risks. As shown by ULPIX above, leveraged funds risk 90% draw-downs which can last 16 years or more. I would not go "all-in" on such a bet, or anything even close to that.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.