- Leveraged ETFs like UPRO are risky but potentially high-reward securities if the market moves your way.
- A long position in UPRO is a bet on the continued upward movement of the S&P 500.
- While historical indicators are signaling that the S&P is high, investors should exercise caution and avoid extremely volatile securities like UPRO.
- Investors who want to consider UPRO should wait for a major market correction and use the ETF to supercharge returns in the recovery.
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The ProShares UltraPro S&P 500 (NYSEARCA:UPRO) has the potential to hugely magnify the returns of an investor's portfolio, but the leverage the ETF uses is a double-edged sword and with multiple threats on the horizon for equities, investors should take a backseat and wait for a major market correction before considering allocating funds to UPRO.
What UPRO Does
UPRO is a leveraged ETF. It seeks to replicate the daily movements of the S&P 500 multiplied by a factor of three by using financial derivatives and debt. For example, if the S&P 500 increased by 2% in a day, UPRO's price should increase by three times that amount (6%). Conversely, if the S&P 500 were to decrease on a given day, UPRO should decline in price by whatever the percentage decrease of the S&P was, multiplied by a factor of three.
Conventional wisdom is that leveraged ETFs perform poorly over the long run, due to a phenomenon known as volatility drag. For this reason, they're typically used as a short-term tool to speculate on the daily price movements of the S&P. While it isn't always necessarily true that leveraged ETFs underperform in the long run (as is evident by the exceptional performance of funds such as UPRO since their inception), volatility drag is worth having a look at in order to properly understand how movements in the S&P 500 affect UPRO.
Consider the following extreme example:
- You buy UPRO.
- On the first day, the S&P drops by 20%, the next day it recovers by 25%.
- The S&P ends in the same place it began (0.8 x 1.25=1)
- UPRO would have experienced a 60% drop in price, followed by a 75% recovery.
- UPRO ends the two days down 30% (0.4 x 1.75 = 0.7), while the S&P itself has not changed in price.
As you can see, the fact that UPRO tracks the daily movements in the S&P can cause it to have price decreases when the S&P is largely flat.
While Leveraged ETFs underperform their leverage factors (3x in UPROs case) on days when their underlying index's movement alternates from a red day to a green day, or a green day to a red day, they benefit from their leverage factors when the underlying index moves homogeniously upward.
To illustrate this point:
- You buy UPRO.
- The S&P 500 goes up 10% the first day and 10% the second day resulting in a net 21% increase over the two days (1.1 x 1.1 = 1.21).
- UPRO goes up 30% and 30% for a net 69% increase in price over the two days (1.3 x 1.3 = 1.69)
- 69% is more than three times 21% (63%), so UPRO has outperformed relative to its three times leverage.
Seeing this, it becomes clear that buying UPRO is a bet on the continued upward movement of the S&P 500. Taking these bets at the right times can result in mind-boggling gains. Buying UPRO at the bottom of the coronavirus crash would've yielded over 450% returns in a matter of months. In the same time period, an investment in the SPDR S&P 500 Trust ETF (SPY) would have yielded returns of roughly 70%. An investment in UPRO would have outperformed its leverage factor by more than double, granting investors returns of over 6X what SPY returned in the same timeframe. Needless to say, buying in at the wrong time can cause equally mind-boggling losses.
A Fundamental Analysis Of UPRO
Since UPRO is ultimately a bet on the S&P 500, looking at the index and the typical metrics used to gauge if it's over or under valued is the best way to determine if UPRO will continue to yield great returns for investors over the next few years.
The S&P 500 has been at the center of a lot of debate recently, regarding the potential of a stock market bubble. The index currently trades at an estimated P/E multiple of roughly 38, well above the index's typical P/E multiple and almost double the index's January 1, 2020 multiple of 24.88.
Similarly, the Buffet indicator, a metric to determine if equities are generally fairly valued, which divides the combined market caps of all listed companies in the USA by the nation's total GDP, is signaling red flags. The Buffet indicator recently overtook the previous highs it reached during the dot-com bubble of the late 90's and is indicating that the index may be massively overvalued.
Both these metrics are however in some ways flawed. The P/E ratio doesn't consider the temporarily low earnings of some companies in the S&P, which are expected to rebound quickly amidst global vaccine rollouts and significant easing of lockdown protocols. The Buffet indicator on the other hand ignores the increasing rate of globalization, which allows American companies to supplement their earnings growth by expanding globally, allowing overall earnings to grow faster than the long-term GDP growth rate of the United States.
Even though these metrics have their flaws, they shouldn't be disregarded. Other threats loom around the corner for equities. Rising US bond yields have recently caused stocks to drop, indicating possible weakness in the market and this trend should be expected to continue as bond yields move towards their pre-pandemic levels.
How UPRO Can Benefit Your Portfolio
Source: Created by author using data from Yahoo Finance
Looking at a graph showing the cumulative value of a hypothetical 100-dollar investment in UPRO (assuming no tracking error) compared to a 100-dollar investment in an S&P 500 representative index in 1930, it's abundantly clear that UPRO delivered similar returns with far, far more volatility.
Investments in UPRO after major market corrections did however produce large and quick returns. Investors willing to take on some risk in their portfolios may benefit from allocating a small portion of their total funds (not exceeding 10%) to a high risk, potentially high reward investment in UPRO after the S&P has stabilized and shown some signs of recovery subsequent to a correction. Historically, as per the graph above, this method would have produced great returns post the past three major market corrections, provided that investors sold out at the right time (which is easier said than done).
Ultimately no investment in UPRO is ever inherently safe, no matter the perceived margin of safety in the S&P 500 at the time. As such, it is most suited to experienced investors with a deep understanding of the security and the risk tolerance to endure the volatility that high leverage brings.
UPRO is currently not a buy. While I'm not definitively stating that the S&P is overvalued, there are certainly several warning signs. Uncertain market conditions, historically high valuations and rising bond yields all present threats to the S&P 500 after the longest bull market in history shrugged off a pandemic in a matter of months.
It's difficult to say how the S&P will react to changes in lockdown restrictions and a reopening of the economy. It's also difficult to justify any kind of investment in an ETF as volatile and risky as UPRO when uncertainty currently permeates ever corner of the market.
Investors who want to consider UPRO should consider allocating a high-risk portion of their equity portfolio to an investment in UPRO after a major market correction to have the best chances of maximizing returns from the leveraged exposure UPRO offers.
This article was written by
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