Leveraged ETF's Can Reduce Risk? Yes, really they can.

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Despite their huge popularity, leveraged ETF's have gotten lot's of bad press in the econoblogosphere. Specifically alot of negative opinion about the value trap design of these ETF's. No, I am not going to debate that point, or remind everyone that the leveraged ETF's are very clear about the leverage factor being applied on a daily basis. What I wanted to mention is that I think in some cases, these leveraged ETF's can actually reduce one's risk to very bad market crashes (or very high rallies if you are short an index or sector fund).

How Can Leveraged ETF's Reduce Portfolio Risk?

Let's suppose you plan to be long the market for 6 months and are not much of a trader and plan to just buy a broad index ETF. For simplicity, we will say we have $100 to invest and are going to put all $100 in IWM which is a Russell 1000 Index ETF. An alternate way to construct a analogous portfolio would be to instead buy 1/3 of the portfolio, $33.3 of BGU which is a 3 times leveraged Russell 1000 ETF. The remaining 2/3 of the portfolio you will keep in cash. So since the BGU is a 3x leveraged ETF, having $33.3 of that is equivalent to having $100 of IWM, and the rest of the BGU portfolio I leave in cash, I have created an equivalent portfolio. Or have I? Let's look at some scenarios of what would happen with some market scenarios. I am interested in discussing risk reduction here so I will focus mostly on the downside. This table summarizes some outcomes of what would happen given various moves in the Russell 1000:

So, if the Russell 1000 goes up, both portfolios go up roughly the same. If the Russell goes down 20%, both go down to about $80. But look what happens with a real bad scenario. If the Russell goes down 50%, the IWM portfolio goes down to $50 but the BGU portfolio only goes down to $67. And if the Russell goes down 75%, the IWM portfolio is down to $25 while the BGU portfolio is still only down to $67! Huh? I am actually simplifying the BGU portfolios but the most I can lose on the BGU is everything which is only $33.3 invested. The rest of the portfolio, $66.6, is in cash so I can't ever see the portfolio go below that no matter how low the Russell 1000 goes.

So, if you use leveraged ETF's to construct an equivalent position by only investing 1/leverage of the leveraged ETF than you would have invested in the actual index or sector ETF, then I believe you can actually limit significantly your downside risk in extreme events.

Let's Look at an Example from the recent past

The 3x leveraged ETF's have not been trading that long, but the 2x leveraged ETF's have been trading longer. So here is a simulated portfolio comparison starting with $100k in two accounts. One putting all $100k in SPY and the other putting $50k in SSO (which is a 2x leveraged S&P 500 ETF) with the remaining $50k just being cash (click on the graph for larger image).


So notice what happened as the market really tanked last year and this March. The SPY portfolio got significantly lower than the equivalent SSO portfolio. The dashed line shows the minimum the SSO portfolio can ever get which is $50k, a 50% loss, if SSO goes to zero. The SPY portfolio could lose everything theoretically.

The fineprint, footnotes, and caveats...

• I did not consider getting paid interest on the cash so the leveraged equivalent portfolios actually would have done a bit better in real life.
• This is not the same thing is buying a 1x ETF like SPY with margin to get leverage! That would actually result in a much more risky portfolio where you could not only lose everything but more than everything!
• Don't think you can do this strategy and then just put 100% of the portfolio into the leveraged ETF. If you do that, you will lose money faster than just buying the normal index fund.
• I am not suggesting one hold 2x and 3x leveraged ETF's for long long term investments because I think the value destruction thing is a real problem long term. But for shorter term like months to a year or two, that effect appears small and you need to balance that with the benefit of risk reduction with this strategy and offset it with interest made on the cash.

I actually have been doing this some since last year in managing money and I like how it feels. Let me know what you think. Am I missing something here?

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