Leveraged Index Funds

[mntnmn117]

So leveraged index funds get a bad rap as they double the risk/reward but do so imperfectly and end up closer to 1.5X UP/ 2.5X DOWN. The cost of the leverage has to be paid right. Where I'm getting lured in is viewing them as a more variable and uncorrolated asset as part of a well constructed portfolio. I've playing around enough on portfolio charts to grasp the effect of uncorrelated assets and rebalancing.

The idea is by adding say 10-20% of a double leveraged index fund you can increase the expected return of the whole portfolio without increasing the risk much because is such a small portion of the portfolio. Its like having a portfolio allocation that adds up to over 100% because some of your portfolio is actually double leveraged.

The idea is something like 60% Total Stock Market, 20% 2X Total Stock Market, 20% Bond. You've created a portfolio thats still 20% bond but 100% equity. You get the higher average return from holding 100% equities and the stability from 20% bonds. Even with the cost of leverage I'm struggling to find any huge holes in the plan.

I would like feedback if I'm missing something here or have I added significantly more risk than I realize.

[zoro]

yes. this is a bad idea. look up the constant leverage effect, due to daily rebalancing there is significant friction on these etfs.  Worse than that it is a power function of the degree of leverage, and even worse than that it is a function of volatility. so you may convince yourself that you have a profitable situation with them at the moment with volatility (sigma) being 15, but when the market experiences a dislocation and volatility goes up to 80 like it did in the GFC they start to loose massive amounts of money (look back at some of these that existed in 2008)

Here is a paper that explains the math better than I could in text here with out the ability to use symbols.

https://www.sciencedirect.com/science/article/abs/pii/S1544612310000310

[MustacheAndaHalf]

The clearest way to see volatility drag is by comparing an S&P 500 ETF ("SPY") with a 3x ETF ("UPRO") that tracks the same index.  Ignoring dividends, the price of the S&P 500 hasn't moved much in 2 years.

Comparing Jun 7 2021 to Jun 7 2023 (today):
SPY : $422.59 -> $428.03   +1.29%
UPRO : $54.13 -> $42.78   -20.96%
https://finance.yahoo.com/quote/SPY/history?p=SPY
https://finance.yahoo.com/quote/UPRO/history?p=UPRO

[HeadedWest2029]

Reminds me of the idea behind WisdomTree Efficient Core ETF (NTSX) https://www.wisdomtree.com/investments/-/media/us-media-files/documents/resource-library/investment-case/the-case-for-the-efficient-core-fund-family.pdf

90% stocks, 10% bonds levered up to 60% notional exposure for effectively a 90/60 asset allocation.  Keeps you stock heavy, but in theory juicing the bond part based on the history of bonds being relatively uncorrelated to stocks.  The problem is they launched when bond yields were on the floor and they didn't provide much cover for when stocks crashed and the fed started raising rates.  But now that the fed has done the work...I can see the historic norm resuming with bond prices going up when a recession hits and the fed has to cut. 

[VanillaGorilla]

The clearest way to see volatility drag is by comparing an S&P 500 ETF ("SPY") with a 3x ETF ("UPRO") that tracks the same index.  Ignoring dividends, the price of the S&P 500 hasn't moved much in 2 years.

Comparing Jun 7 2021 to Jun 7 2023 (today):
SPY : $422.59 -> $428.03   +1.29%
UPRO : $54.13 -> $42.78   -20.96%
https://finance.yahoo.com/quote/SPY/history?p=SPY
https://finance.yahoo.com/quote/UPRO/history?p=UPRO

Ouch.

A few years ago I read the "Hedgefundie's Excellent Adventure" series on Bogleheads and found it intriguing. Checking the performance over the last ten years today is sobering - HEA didn't really improve on VTI since 2013.

Given that 10 years is a reasonable timeframe to reach FI that's not very compelling.

[MustacheAndaHalf]

HedgeFundie Excellent Adventure (HFEA) combined S&P 500 and long-term bonds, both with 3x leverage.  That mix failed in 2022, taking losses of -57% and -73%, respectively.  The idea was to profit off the lack of correlation between stocks and bonds - but you need to keep going in years like 2022 for that result.  But OP isn't pursuing a 300% leveraged portfolio, but something more mild to slightly boost returns.

The idea is something like 60% Total Stock Market, 20% 2X Total Stock Market, 20% Bond. You've created a portfolio thats still 20% bond but 100% equity. You get the higher average return from holding 100% equities and the stability from 20% bonds. Even with the cost of leverage I'm struggling to find any huge holes in the plan.

Some people in the accumulation phase have almost no bonds, which achieves a similar result.  You would need a plan to rebalance, where you sell the winning stocks and buy bonds which have gone nowhere.  Have you done that before?  It would be even harder to start doing that once you add leverage to the equities.

[Financial.Velociraptor]

I have gone round and round trying to find a way to exploit leveraged ETFs, including strategies including shorting them.  As squirrely as they are, the market somehow finds a way to treat them efficiently.  After exploring dozens of arbitrage strategies, I found none that were statistically sound.  They are dogs and not even shortable dogs.  Leverage kills in both directions!