Investing in a leveraged index ETF for retirement. Risky?
I'm 23, and in addition to my 401k at work, I have a few thousand saved in an IRA. Right now I have it sitting in Treasurys earning around 3%.
Over the past 50 years the S&P has averaged around 11% per year in total returns. I'm perfectly willing to invest it in an index (like the S&P) or in a few bellwether-style single stocks (think Warren Buffet: KO, BAC, JNJ, etc). Most mutual funds underperform the market, so I'm not really interested in trying to pick those out at this point (unless you have a convincing argument).
I'm looking for feedback on the idea of investing the IRA balance in a 3x leveraged S&P ETF, specifically UPRO. My thinking: If the S&P averages 11%, this should average ~33%, minus fees of about 1%. The balance of the IRA is about k, and I'm not drawing retirement for another 40 years, so if somehow I "lose everything" it's not going to ruin my life. My future contributions to this IRA will probably be put in something safer, but I'm willing to take a risk now.
Is my thinking on how this 3x leveraged ETF works correct, or am I missing something?
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It is actually a good idea, if you plan on investing for 25+ years. If you look at (hypothetical, zero-error tracking) historical data, you will see that you almost always do MUCH better investing in UPRO than SPY if you have a long time horizon. Since 1950, the annualized growth rate is just over 16%. Most people who say it is a bad idea haven't actually looked at what the hypothetical returns would be from real SPY data. There is decay during periods where the underlying index fund is flat, however this effect isn't nearly as bad as it is commonly exaggerated to be. There are other costs besides the decaying effect, for example the expense ratio is usually 0.95-0.98% on leveraged etf's. There are also other hidden costs incurred while operating these funds such as the commissions and bid/ask spread, which could potentially have a greater effect than the decay that others talk about. The extent is in the fund performance.
Another thing to think about, however, is that the investment will be more volatile. So, you would see the value of your portfolio vary widely. For example, the maximum drawdown (again, using hypothetical data) was 97.7% for the UPRO in the early 2000's.
In any case, I'm not trying to convince you to buy UPRO. However, you should know that you aren't crazy if you buy it and plan to hold long term. You are not guaranteed to lose money over the long run.
Disclosure: I hold shares in UPRO.
Bottom Line: If the S&P is at 1600 now, then one year from now it is at 1600 still, you will be way down. Leveraged ETF's suffer from decay, so you have two weights pulling it down and only 1 pushing it up. Also, if you are looking at an ETF that uses futures, the you Must understand futures, contango, and backwardation. You're swimming with sharks don't forget.
I just compared UPRO and SPY from the time this question was originally posted on October 19th, 2011 through today (September 7th, 2016). See the chart here.
The return for SPY was 78.7% and the return for UPRO was 427.57%. I looked at nearly every 12 month segment over those 5-ish years and about 25% of the time SPY outperformed UPRO, and the other 75% of the time, UPRO outperformed SPY. UPRO was extremely volatile, and I'm not sure I could have held onto it for that entire time period, but over the ~5 year period since this question was posted UPRO performed 5x SPY.
I hope our friend didn't listen to the early answers to his question. I'm not sure we can count on market conditions being the same as the last 5 years, but if they are - this strategy might pay off.
Disclosure: I don't own any UPRO shares, but I'm now considering buying some.
Leveraged ETF's don't work that way. They only provide the expected leverage over the short term - maybe a few days or weeks. On time frames longer than that, they go down and do not track the index.
You can see for yourself by comparing UPRO and S&P 500 on the same chart. The longer the time frame, the greater the difference.
By the way, one solution is to buy the unleveraged S&P 500 index on a regular basis (like monthly). Look for the one with the lowest fees (like Vanguard).
Another solution is to buy when the market is down. Since you will not be using the money for 40 years, this strategy would (in theory) provide much better returns.
Let's suppose that you used a 3x during the 1980s with the Nikkei. How would you be looking right now?
Now, a few voters here may be angered that I don't write out a long answer, but the image I show is exactly what's wrong with these leveraged funds. They aren't too bad if you're timing is perfect, but if our timing was perfect, we wouldn't be using index funds anyway.
YOU ARE NOT CRAZY. This is the RIGHT thing to do over the long term. Will it track the index exactly 3x? NO! Yes, we all get the daily rebalance and the 95bps in annual fees. However, if the trajectory of the S&P 500 over decades is up, you will come out greater than if you owned a vanilla S&P ETF. Yes, no question - we hit a recession, depression, etc....your investment will become crumbs, but again....the S&P will come out higher over time and you will rebound. The volatility will be very high, but this is the right thing to do. Cycle peak to cycle peak you will outgain massively, cycle peak to cycle trough will be extremely painful....you need to just keep contributions consistent every month and tuck it in the drawer. In 30 years....no brainer. If you believe the market will be flat over 30 years, you will get smoked, but we all know that's not true. Again, you may not get 33% CAGR....but it will be greater than the market.
Keep in mind, if the S&P were up 10% one day and down 10% next day, I am down 1%. But triple this, and 1.3 x .7 is .91, down 9%. This phenomenon is enough to make these 3x type ETFs not recommended for the long term.
Since you are considering this strategy with your hard-earned money, I respectfully suggest this exercise. Take an X day period, 10 days, 100, you decide. I'd go high. Create a spreadsheet with a column of the S&P index and next column its return for that day. In next column, triple it, and then calculate total return for the period. I may do this very thing for an article I plan to write, a follow on to my "ETF'd" which focused on the inverse ETFs out there.
My simple example was to exemplify one simple point, returns are cumulative. If the S&P can be down 1% over a 2 day period, but your triple ETF isn't down 3%, but a full 9%, what do you think you'll learn from the spreadsheet exercise? Be sure your time period includes the week the S&P moved over 50 points each day. Over a long period, those volatile days will happen with some regularity.
@chris thanks for the comments, it seems my original response was too simplistic, I added further thoughts with this edit.
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