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ETFs, Volatility and Leverage: Towards a New Leveraged ETF

27 points by smabie 7y ago

nlitened 7y ago
Wow, I couldn't even get myself to finish reading this article. This is based on a very dangerous, ignorant understanding of how markets work. Whatever "advice" there is, please ignore it.
- mpoon 7y ago
  Could you expand a bit further on what you think the OP's misunderstanding of the market is?
  - nlitened 7y ago
    One huge example is an assumption that portfolio returns are normally distributed. That’s not a minor nitpick, this invalidates every formula that goes after.
    - deleted 7y ago
      [deleted]
    - mpoon 7y ago
      OP does address this near the end of the post.
    - jannotti 7y ago
      Well, you did say you didn't finish it. So would it surprise you to learn that topic is addressed directly?
      - nlitened 7y ago
        Thats a fair assumption. But I did skim to the part that attempted to address non-normality—it doesn’t. Under non-normality, not a single formula in this post holds (“standard deviation” does not exist).
    - smabie 7y ago
      Hi, I wrote the post. I discussed the problem of non-normality in the post. Moreover, if non-normality is the problem, then pretty much all of modern finance is invalidated. Instead of saying its all bullshit, a better approach is to realize the assumptions of the model and use some discretion in trading based on its output.
      - nlitened 7y ago
        > Moreover, if non-normality is the problem, then pretty much all of modern finance is invalidated. I’d say, finance from the 70s is invalidated. And it has been invalidated countless times with all the major mutual funds going bust. I’d love to encourage you to read more on this topic. Taleb’s “The Black Swan” is a good start, his other books are also good.
        smabie 7y ago
        Black Scholes, VaR, factor models, CAPM, modern portfolio theory, etc are all based on the normal distribution and are all still used in industry today. Every quant fund in the world is using models that assume a log normal distribution of returns. Moreover, Taleb certainly used models based on log normal distributions at his hedge funds.
- smabie 7y ago
  I wrote the article and I'm not offering advice, I'm delving into the mathematical implications of leverage on portfolio returns and volatility. I think you're deliberately being dismissive and rude without really offering any advice or constructive criticism. Moreover, I don't believe you actually understood the post, which isn't surprising, as you weren't even willing to read it.
  - nlitened 7y ago
    I am sorry for being rude and dismissive. My goal was not to hurt you (you are obviously learning, and I respect you for that), but to warn others who might think these ideas are reasonable and lose money as a result.
ridruejo 7y ago
“ This strategy also greatly reduces the risk of ruin, as the S&P 500 would need to lose at least 1/3 of its total value in a single day for the fund to be wiped out. Though certainly imaginable, this event is unlikely as the biggest single day loss in the history of the S&P 500 was Black Monday in 1987, in which around 20% of value evaporated from the S&P 500 in a single day.” That didn’t age well (article is from last October)
- qeternity 7y ago
  How? The recent losses were nothing compared to Black Monday, especially after a massive 2019.
  - dmurray 7y ago
    It dropped 12% on one day in March, not as big as the 20% on Black Monday but not "nothing". And the bull market of 2019 isn't really relevant when the article focuses on ETFs that leverage single-day moves.
- shmoogy 7y ago
  It's almost impossible to happen, there are three circuit breakers, 7, 13, and 20%. After 20% the market closes for the rest of the day. I think it's only possible if the 20-33% drop happens at the very end of trading where the circuit breaker no longer can occur for the day.
PhantomGremlin 7y ago
Existing leveraged ETFs are a scam, designed only to fleece "muppets" (as a Goldman Sachs guy once called us). Here's a real life example. You can buy a financial instrument that purports to hold gold bars on your behalf. Its symbol is GLD. In the past year GLD price has moved from roughly $123 to $153, more or less equal to the price change in 0.1 oz of gold. But that movement isn't enough for some people. They want leverage. So two leveraged instruments were invented. Cleverly named NUGT and DUST. Purported to achieve 2x moves in Bullish and Bearish gold directions, respectively. But let's look at NUGT price from 1 year ago to now. $20.75 -> $7.72. DUST is even worse. $17.33 -> $2.56. A lot of this under-performance is because of the friction involved in leveraged ETFs borrowing and using futures. (This has been explained in great detail by others, I won't attempt it). Summary: GLD (the commodity) 24% gain, NUGT 63% loss, DUST 85% loss. Yes yes, the purveyors of NUGT and DUST will tell you that they're not meant to be held for 1 year. They're for very short term. But they're just trying to mislead you. The fact that both directions lost so much money means that these products do nothing but scam muppets. The SEC should never have allowed ETFs like that.
- raincom 7y ago
  NUGT, DUST, JNUG, JDST are not based on the gold, but on the gold miners. NUGT/DUST & JNUG/JDST are based on GDX and GDXJ respectively. Usually gold miners (GDX/GDXJ) lag behind gold prices. Many in the market know that gold price is range bound. That's why you can't expect similar moves across GLD and GDX/GDXJ. Leveraged ETFs are bad if the underlying is more volatile. Gold miners are more volatile than biotech(say, IBB), which is more volatile than SPY, QQQ. Go for leveraged bull ETFs on the less volatile underlying, and in the bull market: TQQQ, UPRO, etc. If one wants to capture some short term gains, go for LABU (3x IBB). Leveraged instruments are path dependent. If the underlying ETF is choppy, you are not going to make any money--be it leveraged bull/bearish ETF. An example of choppy/sideway moves in week: 0.5%, -0.45%, +1.2%, -1.3%, 0.25%. In such a market, just stay away from leveraged ETFs.
  - PhantomGremlin 7y ago
    If one wants to capture some short term gains, go for LABU (3x IBB). A perfect example of the fleecing of the muppets I'm talking about. IBB one year performance is $114 -> $106. In the same timeframe LABU $65 -> $20. How does the SEC allow that? It's fucking disgusting. The only way to "win" with ETFs like that is to short them, short them, and short them again. Edit: sorry. Didn't emphasize the obvious, real, way to "win" with ETFs like that. You create them and sell them to muppets. Billy Ray figured this out pretty quickly in Trading Places: Mortimer Duke: Tell him the good part. Randolph Duke: The good part, William, is that, no matter whether our clients make money or lose money, Duke & Duke get the commissions. Mortimer Duke: Well? What do you think, Valentine? Billy Ray: Sounds to me like you guys a couple of bookies. Randolph Duke: [chuckling, patting Billy Ray on the back] I told you he'd understand.
anonu 7y ago
Leveraged ETFs are not leveraged in the traditional since as one might expect. The article misses this point and the author should rectify and clarify immediately. Leveraged ETFs promise the daily return. They are reset every single day. So your return over N days is completely path dependent. Even a positive return of the benchmark may result in a negative return in a leveraged ETF if that path was volatile... Leveraged ETFs are trading tools. Do not hold them in your portfolio for more than a few days.
- raincom 7y ago
  Whoever buys leveraged ETFs should know that "leverage" is not used in the traditional sense. I don't see nothing wrong with the author's usage of leverage.
- smabie 7y ago
  "These ETFs simply aim to match the relative daily returns of their respective index and occupy the bottom left spot on the aforementioned two dimensional spectrum. A closely related (albeit far less popular) type of product that occupies the bottom middle is the leveraged ETF. A leveraged ETF seeks to obtain a daily exposure on an underlying index scaled by a constant l; which, at this time, is somewhere between -3 and 3 for products currently on the market. If l is less than zero, the ETF provides short exposure to the index and are often called "bear" ETFs; conversely, if l is greater than zero, the ETF provides long exposure to the index, commonly referred to as "bull" ETFs. These securities are usually implemented by means of a rolling futures strategy." "At face value, a retail investor might assume that if the S&P 500 returned 10% in a given year, a 3x leveraged ETF would return 30%. Fortunately or unfortunately depending on your perspective, this is not the case as the ETF seeks to maintain a 3x multiple on the daily return of the S&P 500 instead of the annualized return." The post is about how the conventional wisdom behind these ETFs as "trading tools" is simply not true. All these ETFs do is to increase your beta exposure, in much the same way that buying high beta stocks increase your beta exposure. Practically speaking, there's little difference between a portfolio of stocks with an average beta of 2 and a 2x levered S&P 500 ETF. The risks are the same. Yet, no one goes around calling AMD (which has a beta of 2.83) a single day "trading tool." In fact, holding AMD is way riskier than holding a 3x S&P 500 ETF!
keanzu 7y ago
Three questions: What is the cost of the leverage and how does that affect returns What is the friction cost of all the trades needed? Where is part 2?
raincom 7y ago
Your analysis kind of matches with Kelly's betting. 3 times is the optimal: https://seekingalpha.com/article/4230171-how-to-apply-card-counting-strategies-to-etf-portfolios https://seekingalpha.com/article/4230171-how-to-apply-card-c...

27 points by smabie 7y ago

Wow, I couldn't even get myself to finish reading this article. This is based on a very dangerous, ignorant understanding of how markets work. Whatever "advice" there is, please ignore it.

mpoon 7y ago
Could you expand a bit further on what you think the OP's misunderstanding of the market is?
- nlitened 7y ago
  One huge example is an assumption that portfolio returns are normally distributed. That’s not a minor nitpick, this invalidates every formula that goes after.
  - deleted 7y ago
    [deleted]
  - mpoon 7y ago
    OP does address this near the end of the post.
  - jannotti 7y ago
    Well, you did say you didn't finish it. So would it surprise you to learn that topic is addressed directly?
    - nlitened 7y ago
      Thats a fair assumption. But I did skim to the part that attempted to address non-normality—it doesn’t. Under non-normality, not a single formula in this post holds (“standard deviation” does not exist).
  - smabie 7y ago
    Hi, I wrote the post. I discussed the problem of non-normality in the post. Moreover, if non-normality is the problem, then pretty much all of modern finance is invalidated. Instead of saying its all bullshit, a better approach is to realize the assumptions of the model and use some discretion in trading based on its output.
    - nlitened 7y ago
      > Moreover, if non-normality is the problem, then pretty much all of modern finance is invalidated. I’d say, finance from the 70s is invalidated. And it has been invalidated countless times with all the major mutual funds going bust. I’d love to encourage you to read more on this topic. Taleb’s “The Black Swan” is a good start, his other books are also good.
      - smabie 7y ago
        Black Scholes, VaR, factor models, CAPM, modern portfolio theory, etc are all based on the normal distribution and are all still used in industry today. Every quant fund in the world is using models that assume a log normal distribution of returns. Moreover, Taleb certainly used models based on log normal distributions at his hedge funds.
smabie 7y ago
I wrote the article and I'm not offering advice, I'm delving into the mathematical implications of leverage on portfolio returns and volatility. I think you're deliberately being dismissive and rude without really offering any advice or constructive criticism. Moreover, I don't believe you actually understood the post, which isn't surprising, as you weren't even willing to read it.
- nlitened 7y ago
  I am sorry for being rude and dismissive. My goal was not to hurt you (you are obviously learning, and I respect you for that), but to warn others who might think these ideas are reasonable and lose money as a result.

ridruejo 7y ago

“ This strategy also greatly reduces the risk of ruin, as the S&P 500 would need to lose at least 1/3 of its total value in a single day for the fund to be wiped out. Though certainly imaginable, this event is unlikely as the biggest single day loss in the history of the S&P 500 was Black Monday in 1987, in which around 20% of value evaporated from the S&P 500 in a single day.” That didn’t age well (article is from last October)

qeternity 7y ago
How? The recent losses were nothing compared to Black Monday, especially after a massive 2019.
- dmurray 7y ago
  It dropped 12% on one day in March, not as big as the 20% on Black Monday but not "nothing". And the bull market of 2019 isn't really relevant when the article focuses on ETFs that leverage single-day moves.
shmoogy 7y ago
It's almost impossible to happen, there are three circuit breakers, 7, 13, and 20%. After 20% the market closes for the rest of the day. I think it's only possible if the 20-33% drop happens at the very end of trading where the circuit breaker no longer can occur for the day.

PhantomGremlin 7y ago

Existing leveraged ETFs are a scam, designed only to fleece "muppets" (as a Goldman Sachs guy once called us). Here's a real life example. You can buy a financial instrument that purports to hold gold bars on your behalf. Its symbol is GLD. In the past year GLD price has moved from roughly $123 to $153, more or less equal to the price change in 0.1 oz of gold. But that movement isn't enough for some people. They want leverage. So two leveraged instruments were invented. Cleverly named NUGT and DUST. Purported to achieve 2x moves in Bullish and Bearish gold directions, respectively. But let's look at NUGT price from 1 year ago to now. $20.75 -> $7.72. DUST is even worse. $17.33 -> $2.56. A lot of this under-performance is because of the friction involved in leveraged ETFs borrowing and using futures. (This has been explained in great detail by others, I won't attempt it). Summary: GLD (the commodity) 24% gain, NUGT 63% loss, DUST 85% loss. Yes yes, the purveyors of NUGT and DUST will tell you that they're not meant to be held for 1 year. They're for very short term. But they're just trying to mislead you. The fact that both directions lost so much money means that these products do nothing but scam muppets. The SEC should never have allowed ETFs like that.

raincom 7y ago
NUGT, DUST, JNUG, JDST are not based on the gold, but on the gold miners. NUGT/DUST & JNUG/JDST are based on GDX and GDXJ respectively. Usually gold miners (GDX/GDXJ) lag behind gold prices. Many in the market know that gold price is range bound. That's why you can't expect similar moves across GLD and GDX/GDXJ. Leveraged ETFs are bad if the underlying is more volatile. Gold miners are more volatile than biotech(say, IBB), which is more volatile than SPY, QQQ. Go for leveraged bull ETFs on the less volatile underlying, and in the bull market: TQQQ, UPRO, etc. If one wants to capture some short term gains, go for LABU (3x IBB). Leveraged instruments are path dependent. If the underlying ETF is choppy, you are not going to make any money--be it leveraged bull/bearish ETF. An example of choppy/sideway moves in week: 0.5%, -0.45%, +1.2%, -1.3%, 0.25%. In such a market, just stay away from leveraged ETFs.
- PhantomGremlin 7y ago
  If one wants to capture some short term gains, go for LABU (3x IBB). A perfect example of the fleecing of the muppets I'm talking about. IBB one year performance is $114 -> $106. In the same timeframe LABU $65 -> $20. How does the SEC allow that? It's fucking disgusting. The only way to "win" with ETFs like that is to short them, short them, and short them again. Edit: sorry. Didn't emphasize the obvious, real, way to "win" with ETFs like that. You create them and sell them to muppets. Billy Ray figured this out pretty quickly in Trading Places: Mortimer Duke: Tell him the good part. Randolph Duke: The good part, William, is that, no matter whether our clients make money or lose money, Duke & Duke get the commissions. Mortimer Duke: Well? What do you think, Valentine? Billy Ray: Sounds to me like you guys a couple of bookies. Randolph Duke: [chuckling, patting Billy Ray on the back] I told you he'd understand.

anonu 7y ago

Leveraged ETFs are not leveraged in the traditional since as one might expect. The article misses this point and the author should rectify and clarify immediately. Leveraged ETFs promise the daily return. They are reset every single day. So your return over N days is completely path dependent. Even a positive return of the benchmark may result in a negative return in a leveraged ETF if that path was volatile... Leveraged ETFs are trading tools. Do not hold them in your portfolio for more than a few days.

raincom 7y ago
Whoever buys leveraged ETFs should know that "leverage" is not used in the traditional sense. I don't see nothing wrong with the author's usage of leverage.
smabie 7y ago
"These ETFs simply aim to match the relative daily returns of their respective index and occupy the bottom left spot on the aforementioned two dimensional spectrum. A closely related (albeit far less popular) type of product that occupies the bottom middle is the leveraged ETF. A leveraged ETF seeks to obtain a daily exposure on an underlying index scaled by a constant l; which, at this time, is somewhere between -3 and 3 for products currently on the market. If l is less than zero, the ETF provides short exposure to the index and are often called "bear" ETFs; conversely, if l is greater than zero, the ETF provides long exposure to the index, commonly referred to as "bull" ETFs. These securities are usually implemented by means of a rolling futures strategy." "At face value, a retail investor might assume that if the S&P 500 returned 10% in a given year, a 3x leveraged ETF would return 30%. Fortunately or unfortunately depending on your perspective, this is not the case as the ETF seeks to maintain a 3x multiple on the daily return of the S&P 500 instead of the annualized return." The post is about how the conventional wisdom behind these ETFs as "trading tools" is simply not true. All these ETFs do is to increase your beta exposure, in much the same way that buying high beta stocks increase your beta exposure. Practically speaking, there's little difference between a portfolio of stocks with an average beta of 2 and a 2x levered S&P 500 ETF. The risks are the same. Yet, no one goes around calling AMD (which has a beta of 2.83) a single day "trading tool." In fact, holding AMD is way riskier than holding a 3x S&P 500 ETF!

keanzu 7y ago

Three questions: What is the cost of the leverage and how does that affect returns What is the friction cost of all the trades needed? Where is part 2?

raincom 7y ago

Your analysis kind of matches with Kelly's betting. 3 times is the optimal: https://seekingalpha.com/article/4230171-how-to-apply-card-counting-strategies-to-etf-portfolios https://seekingalpha.com/article/4230171-how-to-apply-card-c...