Seeking Alpha

Vanguard Bans Leveraged ETFs, Failing To Consider <100% Allocation

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Includes: UPRO, VBLTX, VFIAX
by: Dane Van Domelen
Dane Van Domelen
Long only, ETF investing, portfolio strategy, bonds
Summary

My portfolio is 1/3 UPRO (a 3x daily leveraged S&P ETF), 2/3 VBLTX (long-term bond fund).

Simple premise: free up assets to generate extra 1-2% annual return.

New Vanguard policy effective Jan. 22: can't buy leveraged ETFs.

Vanguard is looking out for its clients, but their reasoning here is flawed.

New restriction affects me, so I will switch platforms.

Background

I've written a fair number of articles here on Seeking Alpha about leveraged ETFs, which aim to multiply the (usually daily) gains of an underlying index by a fixed integer, typically 2x or 3x. Leveraged ETFs are controversial for numerous reasons, but I think they are very useful for implementing strategies with compelling properties.

For example, leveraged ETFs can be used to free up assets to generate additional returns for a portfolio. Essentially, investing 1/3 of one's assets in a 3x daily leveraged ETF and holding the remaining 2/3 in cash results in the same daily portfolio returns as a 100% allocation to the underlying index. Cash doesn't serve much of a purpose, so a better idea is to put the 2/3 in a relatively low-risk bond fund that might average 1-4% annual returns.

This is the premise for my 1/3 UPRO, 2/3 VBLTX strategy, which I have written about and in fact implemented for the last 3 years. It hasn't worked particularly well recently, but that's just because the bond fund had an unusually big drawdown. Overall, performance over the past 5 years has been pretty good:

Figure 1. Growth of $100,000 from Jan. 17, 2014 to Jan. 18, 2019.

Table 1. Performance from Jan. 17, 2014, to Jan. 18, 2019.

Portfolio CAGR (%) MDD (%) Mean (%) SD (%) Sharpe Alpha Beta
SPY 9.9 19.3 0.041 0.839 0.049 0 1
UPRO/VBLTX (ideal) 12.5 19.5 0.050 0.803 0.062 0.015 0.86
UPRO/VBLTX (3.5% rebalancing) 12.1 19.6 0.049 0.800 0.061 0.014 0.85

In Table 1, we see that in addition to better growth and higher Sharpe ratio, my UPRO/VBLTX strategy has actually had lower volatility than SPY. This is an expected consequence of VBLTX's negative correlation with the S&P. Its negative beta results in the portfolio having net beta slightly less than 1.

Vanguard upgrades warning to ban

For as long as I've been trading leveraged ETFs on Vanguard, I've seen this warning when I submit a trade:

These products generally seek to provide a multiple (leveraged) or opposite (inverse) of the return on a given index for a specific period of time. Most are reset daily, meaning they're designed to achieve their stated objectives for one day only. Performance over longer time periods can differ significantly from daily investment objectives.

Leveraged and inverse ETFs should only be considered by investors who (1) understand the effects of leveraged risk; (2) don't intend to use leveraged or inverse ETFs as part of a buy-and-hold investment strategy; and (3) intend to take a very hands-on approach to managing their investments.

Unfortunately for me, Vanguard has now upgraded the warning to a ban. I received an e-mail on Jan. 8 stating:

Beginning January 22, Vanguard will no longer accept purchases in leveraged or inverse mutual funds, ETFs (exchange-traded funds), or ETNs (exchange-traded notes).

We're making this change because these products and services do not align with our investors' focus on the long term. Most of these investments are designed to deliver their stated returns for only a short period (for example, 1 day or 1 month). Their extremely short-term, speculative nature is contrary to the long-term focus shared by most Vanguard investors.

They also had this note online:

This change is part of an ongoing effort to align the products and services we offer with our investors’ focus on the long term. These investments, which are generally incompatible with a buy-and-hold strategy, run counter to this long-term focus.

...

Leveraged and inverse mutual funds, ETFs, and ETNs are extremely speculative in nature and can be quite volatile.

Who wants fewer options?

I know Vanguard is trying to protect its clients, but adding a restriction that other trading platforms don't impose seems like a bad idea. Given the choice, I think the vast majority of investors would prefer access to the entire universe of ETFs rather than a subset that Vanguard leadership deems suitable for long-term investing.

Faulty reasoning

Vanguard's arguments against leveraged ETFs only really apply to allocating 100% of one's assets to a leveraged ETF, which would indeed be a bad idea. They fail to consider their role in a multi-fund portfolio. Consider these statements:

1. "Performance over longer time periods can differ significantly from daily investment objectives"

True, but this isn't really a problem for strategies like 1/3 UPRO, 2/3 VBLTX, where the UPRO allocation is periodically adjusted. Rebalancing once a month prevents the return on the UPRO holdings from deviating much from the daily multiple. Below, you can see that UPRO maintains a very tight 3x multiple over a 1-month holding period.

Figure 2. Monthly gains for UPRO vs. SPY from 2014 to 2018.2. "Their extremely short-term, speculative nature is contrary to the long-term focus shared by most Vanguard investors."

Again, a wide variety of strategies that incorporate leveraged ETFs could be run long-term. Such strategies can even have net beta < 1, making them arguably less speculative than their famous S&P 500 index fund VFIAX.

3. "Leveraged and inverse mutual funds, ETFs, and ETNs are extremely speculative in nature and can be quite volatile."

Quite volatile in isolation, but not necessarily when paired with other funds. The portfolio volatility is what matters, and that can be kept in check by limiting the allocation to the leveraged or inverse ETF. To see this, consider the volatility of a UPRO/VBLTX portfolio as a function of the UPRO allocation. Volatility is lower than VFIAX provided the UPRO allocation doesn't exceed roughly 35%.

Figure 3. Volatility of UPRO/VBLTX portfolio as a function of the UPRO allocation.

Easy choice: change platforms

Fortunately, it seems to me that Vanguard is no longer particularly unique in the services it provides. Low-cost index funds are dime a dozen and $7 per trade is reasonable but not spectacular. I'll switch to a different platform and implement my strategy there.

Disclosure: I am/we are long UPRO, VBLTX. 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.

Additional disclosure: The author used Yahoo! Finance to obtain historical stock prices and used R (including the "quantmod" and "stocks", and packages) to analyze the data and generate figures.