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Friday, November 10, 2017

Volatility and Leveraged instruments to Lazily beat the markets (Part 1)

For a while now I've been studying leveraged instruments with the idea of finding simple ways to obtain better returns than the market, and to, of course, achieve it in a lazy way.

The easiest way is to obviously own a double leveraged S&P500 ETF such as SSO, which attempts to produce twice the daily return of the S&Ps. Even more aggressive is UPRO, which is triple leveraged.

If things go well and the index rallies, you will instantly have superior returns. Of course, during down days you will also get multiplied pain. No free lunches, as usual.

The main issue with these leveraged instruments is that they are truly intended to replicate the 2x return or 3x return only on a daily basis, but not in the long run. This is why, for instance, in a year like 2015 where the SPX index was basically flat, the triple leveraged UPRO lost 5.25%, way worse than 3x. And in 2013, UPRO gained 118%, which is way better than 3 times the SPX return that year of +30%. In fact, it was almost 4x! So, there are really no guarantees in the long run and the performance largely depends on how the sequence of individual days took place.

Consider the following sequence, starting with a $1,000 investment:

SPX up 1% the first day, then down 1% the second day.
$1000 becomes $1,010 (first day) and then  $999.90 (second day).
After two days, the index is down 0.01%.

UPRO up 3% the first day, then down 3% the second day.
$1000 becomes $1,030 (first day) and then  $999.10 (second day). A 0.09% loss.
After two days, UPRO is down 0.09% which is 9 times worse in this case than the underlying index, which is only down 0.01%!

So, even though, leveraged instruments are designed to produce the return of the index on a daily basis (leveraged 2 or 3x), there are no guarantees that after a sequence of days, the overall returns will match the 2x or 3x goal.

As long as clean trends are formed, the above effect is greatly diminished.
So, for instance if the SPX index losses 33.33% of its value over several months, the triple leveraged UPRO will not lose 100% (3x) but in fact much less than that.

Consider the following sequence, starting again with a $1,000 investment:

SPX down 2% the first day, then down 2% the second day.
$1000 becomes $980 (first day) and then  $960.40 (second day).
After two days, the index is down 3.96%.

UPRO down 6% the first day, then down 6% the second day.
$1000 becomes $940 (first day) and then  $883.60 (second day). The index is down 11.64%.

So, after two days, UPRO is not down by 3x. SPX down 3.96% multiplied by 3 would be  11.88%, yet UPRO is down less than that at 11.64%.
This small example consists of only two days but the effect is magnified over longer periods where, as long as the trend is clean without too much back and forth, the 3x effect is greatly diminished over time on a downtrend.

And, on the way up, a clean trend is better!
Consider the following sequence, starting once again with a $1,000 investment:

SPX up 2% the first day, then up 2% the second day.
$1000 becomes $1,020 (first day) and then  $1,040.40 (second day).
After two days, the index is up 4.04%.

UPRO up 6% the first day, then up 6% the second day.
$1000 becomes $1,060 (first day) and then  $1,123.60 (second day). The index is up 12.36%.

12.36% (UPRO) is in fact better than 3x 4.04% (SPX) !
And this is the result of a clean trend: It benefits you more than 3x on the way up (year 2013). It also damages you less than 3x on the way down. Again as long as a trend is formed.

Therefore, the True Enemy of leveraged instruments is sideways price action.
That back and forth, up one day, then down the next, then up and down, that's where the investor holding these instruments loses more than expected or makes less progress than expected. To the point that the market may be slightly up in a couple of weeks, while UPRO and/or SSO may be flat over the same period. Or a market that goes back and forth, ending up nowhere while the investor holding UPRO or SSO ends up negative (as in the year 2015).

For this reason, many people argue that holding these instruments for the long run is not advisable.
It's true. It is not very wise if they are the only thing you hold, but when you start adding some hedging mechanisms you start to see some very interesting results, which is what I plan to explore.

For simplicity, just think of a scenario where you hold 33% of an account in UPRO.
If the market goes up that year you are likely to more than triple the market return on your position. This position however, represented only one third of your account, so overall, your entire account is up for the year matching the SPX return, or perhaps slightly better, but you have done so while keeping two thirds of your account in cash.

What if we use those two thirds of the account and instead of keeping that portion in cash, we deploy it in another instrument with a long term positive bias but negatively correlated to the market, such as bonds (TLT) ?

Well, here are the individual returns of UPRO, TLT and SPY with dividends for comparison.
At the bottom you will see the combination of 1/3 of the account in UPRO and 2/3 in TLT.
*2017 is not over yet. Performance numbers are as of November 10, 2017

Notice how the average annual return of UPRO is almost 3x that of SPY (even with SPY numbers containing dividends here, which UPRO doesn't pay). However, we don't want to just hold UPRO as it will be painful during market downturns and we need to stay sane.

The combination of one third of the account in triple-leveraged S&P's and the other two thirds in Bonds easily beats the market in the last seven years with an Average annual return of 18.17%, while the SPY has returned 13.37% with dividends included. This simulation assumes that at the beginning of every year the investor adjusts the positions back to 33% UPRO and 66% TLT. Effectively selling high and buying low. Not only are returns higher, but the Average Return to Standard Deviation of returns is also better, suggesting less volatility for the achieved returns.

Naturally, many readers will be curious about 2008, but although we don't have the numbers (UPRO started in 2009), it is easy to see how this two-punch combination would have fared much better than simply holding SPY. The market was down 55% from peak to trough at one point. Because the UPRO allocation is just 33% of the account, we know we obtain approximately "market like" returns on the overall account because of it. So that would be a -55% blow, but as explained earlier in this article, during clear downtrends you will lose much less than that. So, that alone is enough to do better than the market. But now when you consider that the other two thirds of the account were invested in bonds, which returned +34% that year, then you realize that the pain you would have had to endure would have been much much less than a pure market index follower. Your account would have been negative, no doubt about that, but the draw-down (and the suffering) would have been significantly less severe.

Going forward, I will explore similar systems with other instruments, including short/long volatility. Stay tuned.

As of this writing I'm also invested in a combination of ZIV (short medium-term volatility) and TMF (triple leveraged bonds). Inverse volatility instruments like XIV or ZIV are truly explosive, with potential for nice gains but also severe losses. Hence why I'm combining ZIV with triple leveraged bonds. You can also pair them up with just TLT (pure bonds without leverage), still offering some hedging potential as ZIV will fall when volatility increases, which typically happens when the markets go down. So, a combination of short volatility with Bonds (leveraged or not) offers attractive results too.


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