Leveraged Etfs vs s&p500 in bull market
I read everywhere online that leveraged ETFs shouldn't be bought for the long term. Here is a comparison between TECL (Technology Bull 3x) and the S&P 500. As you can see, the CAGR is 32% in the last 7 years.
100,000 invested in S&P 500 in 2011 would be worth 268,000
100,000 invested in TECL in 2011 would be worth 1,510,000
While the first return is not life changing, the second one is.
So my question is, why does everyone say to stay away from leverage ETFs? Is there a flaw in the backtest ? Thank you
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Generally nobody knows which such alternative investments will be profitable ahead of time. It’s easy to fall victim to survivorship bias - only observing the funds that succeeded and ignoring all the ones that failed. There’s also more information now about how history actually unfolded that makes investments in the past seem “obvious” to us now when in fact they were not at the time.
To answer your question about that tech index specifically - nobody knew whether the tech sector would do well or go bust. It did well, so if you pay a lower interest rate on the loan (leverage) than you make in the market, you dramatically increase your ROI. Tl;Dr: it was a risky investment that paid off. Probably worth looking at the many other risky investments in specialty sectors that lose using this method as well.
Leveraged funds offer more return, yes. Also more risk. But actually not just risk of losing three times as much - there are some things people often overlook:
If the S&P trades range bound, without going up or down overall, but making many small up/down movements, then a normal S&P fund will break even. The leveraged will lose. The reasons for this are boring and have to do with how leveraged funds work behind the scenes. But you can see this for yourself by comparing a portfolio of 1:1 bull and bear (inverse) etfs (which will be neutral) to 3x bull and bear etfs (which will decline).
If the S&P goes down more than 33% (happened many times) you can lose more money than you had in your account.
Generally, holding a 3x fund, especially for S&P, is not really that bad assuming it actually does go up. You just have to watch out for the two above problems and also keep in mind that draw downs will be 3x as bad too.
The people saying to stay away from leveraged funds are the same people recommending to hold a very small number of funds (2-4) by picking funds that are very broad and diversified.
Leveraged funds are totally incompatible with that simple portfolio.
There are strategies that use leveraged funds, but they are not set-and-forget. You have to frequently rebalance, to prevent a 30% drop in the market (99% loss in the leveraged fund) from wiping out both the gains from the good years and also your initial investment.
If you are willing to manage holdings in a couple dozen funds (in a tax-advantaged account so the rebalancing transactions don't count as short-term capital gains), then there's nothing wrong with having one or two leveraged funds in the mix.
The problem with your math isn’t the math; it’s the person. In 2008 I bought some SSO (double S&P ETF). The current price is about 3x what I paid, but I didn’t keep it- I bailed when the market tanked because it looked like it might actually go to zero. If your psyche is typical, you would likely have done the same.
First you have to consider a basic mathematical fact. A 5% loss is a larger loss than the following 5% gain is a gain. Let me show you with an example.
Say you have 00 a 5% loss is a 50 dollar loss un-leveraged. That brings you down to 0.
(1000-950)/1000 = 0.05 -> 5%
To get back to where you started how much do you have to gain? If you said 5% you would be wrong.
(1000-950)/950 = =0.0526 -> 5.26%
This problem becomes exponentially worse when you leverage your gains, because you also leverage your losses. As other answers have mentioned.
The reason TECL has been such an amazing run is because there has not been a major loss yet. There will be one sooner or later. When? No one knows, anyone who says they do is a liar. When that loss comes TECL will almost certainly become less profitable. In times when everything is going good triple leveraged is great... until things don't go well, which always happens sooner or later.
TECL performed extraordinarily well because it was a sector the did well and because your time frame does not include any severe market corrections. Unfortunately, TECL only exists since December of 2008 so it can't be used for such a comparison. So let's consider the DJIA.
From the end of the GFC (3/09/08) until now, DIA returned 397% whereas DDM (2X DJIA ETF) returned 1,666% for better than 4X return.
However, if the starting date used is 12/31/07 at the beginning of the GFC then DIA returned 158% while DDM returned 281%, less than 2X. So why the huge discrepancy (4X versus 2X)?
For the GFC (1/01/08 to 3/09/09), DIA returned -49% while DDM returned -79%. If a leveraged ETF loses 4/5 of its value, the road back is much slower because they can only leverage that 20% of remaining value. IOW, the DIA required a 100% rise to break even but the DDM required a 400% rise to do the same.
Another issue for much shorter holding periods is the P&L due beta slippage but I'm going to pass on that explanation since your question dealt with a 7 year long term hold.
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