I am familiar with the decay factor of leveraged ETFs over the long term. However, it seems that using 50% cash, 50% 2X ETF, rebalanced say annually, mirrors the underlying 1X ETF very closely. In fact it is a bit better on a risk adjusted basis.Here is a chart of the comparison from J.H.’s backtest at Portfolio Visualizer:
Blue portfolio: 100% SPY (an S&P 500 index ETF)
Red portfolio: 50% SHV (short-term U.S. bonds), 50% SSO (a 2X leveraged S&P 500 ETF)
These two portfolios gave nearly identical returns from 2008 to the present. I found this to be contradictory to everything I read about leveraged ETFs. A six year back-test should be enough to unveil the presumed decay, but I don't see it.
I am particularly interested in this way of investing as it provides a way to beat SPY without taking all the risk of being all-in. If on the cash component one can earn more than what SSO pays to borrow to buy stock (these days, one can make 2.3% or so using a GIC ladder), then I would say this approach can provide an easy 0.5 - 1% premium over a traditional all-equity portfolio. In essence, the 50% cash deleverages the leverage and can add alpha.
But I do know there is no free lunch in the investment world so I must be missing something. It cannot be that easy. A backtest using synthesized 2X returns that go back to as far as the S&P500 would be an interesting test to validate the theory.
As we can see, the two portfolios end up at the same place, but with somewhat different paths. Unfortunately, this is a side effect of the powerful bull market we’ve seen for 6 years and not a sign that J.H. has found a way to make an extra 1% on his money for free. I can explain this without resorting to math.
A 2X-leveraged ETF takes its cash, borrows an equal amount and uses it all to buy an index (the S&P 500 in this case). The leveraged ETF may actually use derivatives rather than borrow, but that isn’t important here.
Every day, the leveraged ETF rebalances so that it remains 200% exposure to the S&P 500. This means that if the S&P 500 goes up, the leveraged ETF borrows more and buys more stock. If the S&P 500 goes down, the leveraged ETF sells some stock and reduces its debt. On a day-to-day basis, this is essentially a momentum strategy. Unfortunately, the markets tend to revert to the mean; leveraged ETFs buy high and sell low. I gave a more detailed explanation of this effect in a past post.
If leveraged ETFs tend to leak, then how do we explain J.H.’s backtest in the chart above? The answer is the 6-year bull run in stocks. During a strong year for stocks, the leveraged ETF (SSO) maintains 200% exposure to stocks, but SSO grows to be more than 50% of the red portfolio. So, the red portfolio’s exposure to stocks grows above 100% from beginning to end of the year.
On average during a good year, the red portfolio is more than 100% exposed to S&P 500 stocks. So, the reason the red portfolio has kept up since 2008 is that this has been a great period to be more than 100% exposed to stocks. This extra exposure exactly offset the inherent leakiness of the leveraged ETF.
To test this explanation, we can check to see what happens if we eliminate the annual portfolio rebalancing. We should expect the red portfolio to perform much better because its exposure to stocks will keep climbing above 100% instead of getting reset to 100% each year. Here is the chart without rebalancing:
As we can see, the red portfolio won easily. But this only happened because we are focused on a great period of time for stocks. Averaged over all conditions, the 50/50 portfolio with a leveraged ETF will not keep up with the plain vanilla index portfolio. So, there’s no free lunch.