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While we are on the topic of leverage and index funds, can someone explain leveraged index funds to me? If I believe index funds are going to have a positive r

by fyp 7y ago

While we are on the topic of leverage and index funds, can someone explain leveraged index funds to me? If I believe index funds are going to have a positive return, why not try to lever it up as high as possible? For example TQQQ (triple leverage) looks pretty enticing compared to QQQ.

gr2020 7y ago
Leveraged index funds generally work as expected on an intraday basis - but they're not intended for longer term holds. You can of course try it, but things will not turn out as you'd hope. Here's an article describing what happens: https://www.investopedia.com/articles/financial-advisors/082515/why-leveraged-etfs-are-not-longterm-bet.asp https://www.investopedia.com/articles/financial-advisors/082...
- planteen 7y ago
  Outside of tracking error and expense fees, there is a more fundamental issue. When the market goes down X%, you need it to go back up Y = 1/(1-x)-1 to break even. So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. So the average daily noise of the market kills you.
  - Pyxl101 7y ago
    > So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. Can you explain why that is? I would have expected that your gain or loss from the leverage funds relates only to the difference in price between when you purchased and when you sold (multiplied by the leverage).
    - fred256 7y ago
      The leveraged funds like TQQQ reset their leverage on a daily basis.
    - maximente 7y ago
      the leverage amounts typically "reset" daily (not always; read the prospectus) so if you lose 10% (say $100 => $80) at 2x your day 2 base is $80; a 10% gain that day would average out to 0 on net but you would gain 20% of $80 => $96
    - pnako 7y ago
      Because of the triple leverage, a 33.33% drop would entirely wipe out the fund. Back to $0. A 33% drop in a single day has never happened (1987 Black Monday was 22%) but it definitely does happen if you consider a longer time frame. Hence why it's reset daily, as the other two responses explain. And in case it's not been made clear enough: it's the very opposite of a sound investment. It's very much a risk management / trading instrument. It's something you would trade as a hedge or leg of a complex trade; not something you want to hold by itself.
MuffinFlavored 7y ago
I read that 3x leverage is bad because of volatility drag or something like that so 2x "is the sweet spot" SSO is 2x leveraged SP500 https://finance.yahoo.com/quote/SSO https://finance.yahoo.com/quote/SSO Check out the chart since 2007 versus the SP500 index to today. I'm seeing 211% return for SSO, 113% for SPY. Just remember that we've pretty much been in a full on bear market ever since the last recession. Whether or not terrible things would have happened to SSO if we experienced a true recession/crash and whether or not you would actually recover/beat SPY, I have no clue and am not qualified to say. But, based on the cherry picked '07-'19, yes, SSO (2x SPY) beats SPY (1x SP500) 211% to 113%
- smabie 7y ago
  It really depends, see my blog post on the matter (part 1): https://smabie.github.io/posts/2019/10/04/vol.html https://smabie.github.io/posts/2019/10/04/vol.html In short, assuming a normal distribution, your max leverage ratio should be the future expected returns divided by the expected variance. I’m not at a computer right now so I can’t run the math on real S&P returns, but assuming 10% returns and 10% vol and a normal distribution, the highest leverage ratio you would ever be able to justify is 10/10^2 or 10x leverage. In my blog post I looked at the beginning of 2018 up to present. The ideal leverage ratio according to my equation (I’m sure it’s not novel, but haven’t been able to find anyone else talking about it), is 2.99x. Of course, the more skew or kurtosis the distribution has the less accurate this equation becomes. Right now I’m working on a hypothetical S&P ETF that adjusts leverage bases on forecasted volatility and returns. Almost impossible to get right, but my preliminary model has outperformed (not risk adjusted) any fixed leverage I’ve thrown at it.
  - MuffinFlavored 7y ago
    You made a blog post that 10x leverage would be good given the past 12 months (where the market has mainly been up-up-up)? Doesn't that 100% ignore the effects of drag when the market goes down-down-down?
    - smabie 7y ago
vincentmarle 7y ago
You also need to pay interest on the leveraged margin, so on the long term you'll lose more money on interest than you'll gain.
- iopq 7y ago
  Clearly not, gains of the stock market are much higher than interest
- smabie 7y ago
  This isn’t true. Market returns are almost always going to be higher than the borrowing cost. In fact, I can’t think of a single hedge fund that doesn’t use leverage either through: shorting, borrowing, options, or futures. Leverage is almost always the secret sauce to institutional strategies. And if we’re talking about quant funds, without leverage they wouldn’t exist.
  - perl4ever 7y ago
    "Market returns are almost always going to be higher than the borrowing cost" This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever. If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?
    - maximente 7y ago
      for a large number of reasons it's hella hard to make money in finance. you can make whatever the vanguard index fund makes "for free" in your pajamas, so in order to justify your existence as an org within a financial institution you're going to need to put together some returns that are, obviously, way higher than that. so out come things like leverage and derivatives (=> hyper-leverage). and yeah, there are failures, and they lose their shirts, and the beat goes on. but you're probably not going to make very much money (=> last very long) if your rate of return is the same order of magnitude as the collateral you're taking out. it's just not worth it from the POV of the bank.

by fyp 7y ago

gr2020 7y ago

Leveraged index funds generally work as expected on an intraday basis - but they're not intended for longer term holds. You can of course try it, but things will not turn out as you'd hope. Here's an article describing what happens: https://www.investopedia.com/articles/financial-advisors/082515/why-leveraged-etfs-are-not-longterm-bet.asp https://www.investopedia.com/articles/financial-advisors/082...

planteen 7y ago
Outside of tracking error and expense fees, there is a more fundamental issue. When the market goes down X%, you need it to go back up Y = 1/(1-x)-1 to break even. So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. So the average daily noise of the market kills you.
- Pyxl101 7y ago
  > So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. Can you explain why that is? I would have expected that your gain or loss from the leverage funds relates only to the difference in price between when you purchased and when you sold (multiplied by the leverage).
  - fred256 7y ago
    The leveraged funds like TQQQ reset their leverage on a daily basis.
  - maximente 7y ago
    the leverage amounts typically "reset" daily (not always; read the prospectus) so if you lose 10% (say $100 => $80) at 2x your day 2 base is $80; a 10% gain that day would average out to 0 on net but you would gain 20% of $80 => $96
  - pnako 7y ago
    Because of the triple leverage, a 33.33% drop would entirely wipe out the fund. Back to $0. A 33% drop in a single day has never happened (1987 Black Monday was 22%) but it definitely does happen if you consider a longer time frame. Hence why it's reset daily, as the other two responses explain. And in case it's not been made clear enough: it's the very opposite of a sound investment. It's very much a risk management / trading instrument. It's something you would trade as a hedge or leg of a complex trade; not something you want to hold by itself.

MuffinFlavored 7y ago

I read that 3x leverage is bad because of volatility drag or something like that so 2x "is the sweet spot" SSO is 2x leveraged SP500 https://finance.yahoo.com/quote/SSO https://finance.yahoo.com/quote/SSO Check out the chart since 2007 versus the SP500 index to today. I'm seeing 211% return for SSO, 113% for SPY. Just remember that we've pretty much been in a full on bear market ever since the last recession. Whether or not terrible things would have happened to SSO if we experienced a true recession/crash and whether or not you would actually recover/beat SPY, I have no clue and am not qualified to say. But, based on the cherry picked '07-'19, yes, SSO (2x SPY) beats SPY (1x SP500) 211% to 113%

smabie 7y ago
It really depends, see my blog post on the matter (part 1): https://smabie.github.io/posts/2019/10/04/vol.html https://smabie.github.io/posts/2019/10/04/vol.html In short, assuming a normal distribution, your max leverage ratio should be the future expected returns divided by the expected variance. I’m not at a computer right now so I can’t run the math on real S&P returns, but assuming 10% returns and 10% vol and a normal distribution, the highest leverage ratio you would ever be able to justify is 10/10^2 or 10x leverage. In my blog post I looked at the beginning of 2018 up to present. The ideal leverage ratio according to my equation (I’m sure it’s not novel, but haven’t been able to find anyone else talking about it), is 2.99x. Of course, the more skew or kurtosis the distribution has the less accurate this equation becomes. Right now I’m working on a hypothetical S&P ETF that adjusts leverage bases on forecasted volatility and returns. Almost impossible to get right, but my preliminary model has outperformed (not risk adjusted) any fixed leverage I’ve thrown at it.
- MuffinFlavored 7y ago
  You made a blog post that 10x leverage would be good given the past 12 months (where the market has mainly been up-up-up)? Doesn't that 100% ignore the effects of drag when the market goes down-down-down?
  - smabie 7y ago

vincentmarle 7y ago

You also need to pay interest on the leveraged margin, so on the long term you'll lose more money on interest than you'll gain.

iopq 7y ago
Clearly not, gains of the stock market are much higher than interest
smabie 7y ago
This isn’t true. Market returns are almost always going to be higher than the borrowing cost. In fact, I can’t think of a single hedge fund that doesn’t use leverage either through: shorting, borrowing, options, or futures. Leverage is almost always the secret sauce to institutional strategies. And if we’re talking about quant funds, without leverage they wouldn’t exist.
- perl4ever 7y ago
  "Market returns are almost always going to be higher than the borrowing cost" This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever. If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?
  - maximente 7y ago
    for a large number of reasons it's hella hard to make money in finance. you can make whatever the vanguard index fund makes "for free" in your pajamas, so in order to justify your existence as an org within a financial institution you're going to need to put together some returns that are, obviously, way higher than that. so out come things like leverage and derivatives (=> hyper-leverage). and yeah, there are failures, and they lose their shirts, and the beat goes on. but you're probably not going to make very much money (=> last very long) if your rate of return is the same order of magnitude as the collateral you're taking out. it's just not worth it from the POV of the bank.