Investing in ETFs

DeepState said:

For retail investors seeking to trade with leverage, I can see WYSIWG's perspective. For them, futures/CFD remains the main game.

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Yes that's true, there is only one product at the moment providing leverage (over the S&P/ASX 200) which is GEAR - if you are looking for extreme leverage, ETFs are probably not for you

Just seeking some opinion on geared ETFs. I was looking into geared etfs, falling prey to the thought that if I hold an ETF long-term (looooong) then the leverage will boost my returns. Then I got to thinking that perhaps the magnified losses and wins would just cancel each other out.

A quick googling had me concluding that geared ETFs will actually underperform a non-geared ETF over the long-term.

Just wondering what everyone else thought?

Bibliography:
http://news.morningstar.com/articlenet/article.aspx?id=271892

http://seekingalpha.com/article/35789-the-case-against-leveraged-etfs

PS This seems to suggest that geared ETFs might be okay
http://ddnum.com/articles/leveragedETFs.php

Tooth Faerie said:

Just seeking some opinion on geared ETFs. I was looking into geared etfs, falling prey to the thought that if I hold an ETF long-term (looooong) then the leverage will boost my returns. Then I got to thinking that perhaps the magnified losses and wins would just cancel each other out.

A quick googling had me concluding that geared ETFs will actually underperform a non-geared ETF over the long-term.

Just wondering what everyone else thought?

Bibliography:
http://news.morningstar.com/articlenet/article.aspx?id=271892

http://seekingalpha.com/article/35789-the-case-against-leveraged-etfs

PS This seems to suggest that geared ETFs might be okay
http://ddnum.com/articles/leveragedETFs.php

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Your not reading what those links are saying, the EFT's are not simple geared EFT's.

If you gear an EFT then over the long term it will enhance the long term average return, if the ETF returns more positive years than negative you will be in front and vice versa. That's assuming cost of funding is zero and no tax implications.
In reality in today's terms it would need to return in excess of 3% pa to break even at a 50% LVR, an exact figure depends on individual circumstances for tax and how you fund the loan.

clowboy said:

Your not reading what those links are saying, the EFT's are not simple geared EFT's.

If you gear an EFT then over the long term it will enhance the long term average return, if the ETF returns more positive years than negative you will be in front and vice versa. That's assuming cost of funding is zero and no tax implications.
In reality in today's terms it would need to return in excess of 3% pa to break even at a 50% LVR, an exact figure depends on individual circumstances for tax and how you fund the loan.

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Can you explain elaborate a bit more on your first point? I am a newbie.

From what I understoond simple geared ETFs tracking indices underperform because they magnify wins and losses daily rather than annually, which by their math, means you lose in the long-run.

I read also that external gearing, e.g. holding ETFs in a margin account, is a better way to gear ETFs than internally geared ETFs. I find it hard to grasp this conceptually. Hope someone can explain it to me in simple terms.

Tooth Faerie said:

I read also that external gearing, e.g. holding ETFs in a margin account, is a better way to gear ETFs than internally geared ETFs. I find it hard to grasp this conceptually. Hope someone can explain it to me in simple terms.

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Objective: obtain a leveraged exposure to a market.
Say you have $100k in the bank and want $200k in market exposure.

Option 1 (external leverage): You borrow $100k from some place, add this to your own $100k and buy $200k worth of the market.

Option 2 (internal leverage): There is a fund, where, for every $1 in equity, it is matched with $1 of debt which the fund itself borrows from some other place. You buy $100k of this fund. Within the fund, there is $100k of borrowings matching the equity you just put into it. In total, you will now have $200k in market exposure. You, in person, did not borrow a cent. All leverage happens within the fund.


Which is better?

All else equal, if the interest charges for one option is lower than the other, the alternative with the lower interest charges are preferred. Fees will also be a factor. Ultimately, the question is "which costs less to get $200k worth of market exposure?"

Tooth Faerie said:

Can you explain elaborate a bit more on your first point? I am a newbie.

From what I understoond simple geared ETFs tracking indices underperform because they magnify wins and losses daily rather than annually, which by their math, means you lose in the long-run.

I read also that external gearing, e.g. holding ETFs in a margin account, is a better way to gear ETFs than internally geared ETFs. I find it hard to grasp this conceptually. Hope someone can explain it to me in simple terms.

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In addition to Deep State's explanation, US leveraged ETFs can have one VERY important feature.

The 2x or 3x leveraged ETFs seek to replicate daily 2x or 3x performance, not long term.

Whats the difference you ask? The difference between arithmetic and geometric means! eg. if a stock loses 10%, then makes back 11.11% the next day, its back at breakeven.
The 3x ETF however, is -30%, then up 33.33% = 0.93333, leaving you with a 6.66% loss already! Long term, volatility tends to turn your investment to 0 (thats why everyone is fighting to make more leveraged ETFs)

Tooth Faerie said:

Can you explain elaborate a bit more on your first point? I am a newbie.

From what I understoond simple geared ETFs tracking indices underperform because they magnify wins and losses daily rather than annually, which by their math, means you lose in the long-run.

I read also that external gearing, e.g. holding ETFs in a margin account, is a better way to gear ETFs than internally geared ETFs. I find it hard to grasp this conceptually. Hope someone can explain it to me in simple terms.

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skyQuake said:

In addition to Deep State's explanation, US leveraged ETFs can have one VERY important feature.

The 2x or 3x leveraged ETFs seek to replicate daily 2x or 3x performance, not long term.

Whats the difference you ask? The difference between arithmetic and geometric means! eg. if a stock loses 10%, then makes back 11.11% the next day, its back at breakeven.
The 3x ETF however, is -30%, then up 33.33% = 0.93333, leaving you with a 6.66% loss already! Long term, volatility tends to turn your investment to 0 (thats why everyone is fighting to make more leveraged ETFs)

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Oh...yea. Now I think I see where you are coming from.

The reason why things might be as SQ states is that the ETFs move to keep leverage ratios constant. If the market drops by 10%, they reduce the borrowing amount by 10% so that the leverage ratio remains more or less constant. What that means is that you sell low and buy high. It's actually form of insurance to prevent you from going bankrupt as markets go down. Believe it or not, but you are paying for that insurance.

An alternative is to keep your dollar leverage unchanged. It the market falls 10%, you don't change the amount borrowed. If the market then rises 11.11% the next day, you are restored back to the same position. You can do that in a margin account because you control the leverage, not the fund.

However, in the presence of strong trends (relative to volatility), the levered ETF will do better if markets are rising than the alternative of keeping your dollar leverage unchanged. That's because the fund will increase dollar leverage as markets go up. Of course, if markets go down a long way, keeping dollar leverage unchanged will crater you at an increasingly frightening rate.

When you lever, this is a really big issue and there is no right answer. You actually need to have a perspective on what the markets will do in order to figure out what is best. There are break-evens depending on the return expectation, interest/fees and return volatility.

Further, equity markets show excess short term volatility. In other words, the market moves around a lot more in the short term than would be implied if you looked at things over a longer time period. All things equal, this makes keeping the leverage ratio constant within an ETF more damaging to performance.

I suspect that, in reality, ETFs operate within a range of leverage. That's the case for GEAR:ASX anyway. That helps to reduce the impact of that issue of keeping the leverage ratio constant in all situations.

Not straight forward is it?

skyQuake said:

In addition to Deep State's explanation, US leveraged ETFs can have one VERY important feature.

The 2x or 3x leveraged ETFs seek to replicate daily 2x or 3x performance, not long term.

Whats the difference you ask? The difference between arithmetic and geometric means! eg. if a stock loses 10%, then makes back 11.11% the next day, its back at breakeven.
The 3x ETF however, is -30%, then up 33.33% = 0.93333, leaving you with a 6.66% loss already! Long term, volatility tends to turn your investment to 0 (thats why everyone is fighting to make more leveraged ETFs)

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Yes exactly, that's what I gathered from the articles I read. Looking into iShares' GEAR ETF, it also works on doubling daily performance as well. Leading to volatility drag in the long term.

DeepState said:

Oh...yea. Now I think I see where you are coming from.

The reason why things might be as SQ states is that the ETFs move to keep leverage ratios constant. If the market drops by 10%, they reduce the borrowing amount by 10% so that the leverage ratio remains more or less constant. What that means is that you sell low and buy high. It's actually form of insurance to prevent you from going bankrupt as markets go down. Believe it or not, but you are paying for that insurance.

An alternative is to keep your dollar leverage unchanged. It the market falls 10%, you don't change the amount borrowed. If the market then rises 11.11% the next day, you are restored back to the same position. You can do that in a margin account because you control the leverage, not the fund.

However, in the presence of strong trends (relative to volatility), the levered ETF will do better if markets are rising than the alternative of keeping your dollar leverage unchanged. That's because the fund will increase dollar leverage as markets go up. Of course, if markets go down a long way, keeping dollar leverage unchanged will crater you at an increasingly frightening rate.

When you lever, this is a really big issue and there is no right answer. You actually need to have a perspective on what the markets will do in order to figure out what is best. There are break-evens depending on the return expectation, interest/fees and return volatility.

Further, equity markets show excess short term volatility. In other words, the market moves around a lot more in the short term than would be implied if you looked at things over a longer time period. All things equal, this makes keeping the leverage ratio constant within an ETF more damaging to performance.

I suspect that, in reality, ETFs operate within a range of leverage. That's the case for GEAR:ASX anyway. That helps to reduce the impact of that issue of keeping the leverage ratio constant in all situations.

Not straight forward is it?

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Thank you for the detail response DeepState. I'm starting to understand a bit more but still struggling to grasp the concept completely why external gearing is less likely to be detrimental (if that is true at all). I will do further reading to try and understand more.

Let's say you wanted to buy an ASX300 ETF, and put 50% of your money in that index.

Would you just choose 1 ETF, or would you choose multiple ETFs from different companies to protect against risk of whatever.

shouldaindex said:

Let's say you wanted to buy an ASX300 ETF, and put 50% of your money in that index.

Would you just choose 1 ETF, or would you choose multiple ETFs from different companies to protect against risk of whatever.

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1 is fine.

shouldaindex said:

Let's say you wanted to buy an ASX300 ETF, and put 50% of your money in that index.

Would you just choose 1 ETF, or would you choose multiple ETFs from different companies to protect against risk of whatever.

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I don't see much benefit in diversifying 'managers' (custodians?) for the sake of diversifying in this case. You're not trying to manage manager risk, it's a passive strategy. Personally my concern would be the amount of synthetic exposure the ETF has. The less the better for me.

Tooth Faerie said:

Thank you for the detail response DeepState. I'm starting to understand a bit more but still struggling to grasp the concept completely why external gearing is less likely to be detrimental (if that is true at all). I will do further reading to try and understand more.

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There is no universally dominant outcome. The best decision requires some sort of notion as to what the market is going to do...including how volatile it is...and some notion of how much the return on the market exceeds fees and interest. In the absence of that, it is a shrug.

External static gearing works best if the market will never bankrupt you (ie. not fall by enough that your account is totally vaporized) and the market performs in the middle ground of return expectations/volatility. Hard to say what level of leverage that implies. On either extreme of return expectations, or if volatility turns out to be low (in general...crikey, the actual pattern of returns matters here), you are better off with static leverage ratio (internal gearing within an ETF).

Giving some buffer to the leverage ratio as per GEAR:ASX tries to find some sort of middle ground between the extremes. However, even this action can produce worse outcomes than a static leverage ratio under certain conditions.

Basically, gear up 1:1 only if you are confident the market will, on average, deliver a return where the margin of the (annual arithmetic return you expect for the market over the (interest rate)/2)x2, minus the annual expected variance of market returns, is 'well above' the (unlevered expected arithmetic return less half of the annual expected variance of the market). Got that? After that, it is close to a crap shoot as to whether to internally or externally finance (it is an options pricing problem with lots of loose bits).

Rebalancing under conditions of leverage is effectively paying away rebalancing profits to those who do not leverage but can buy dips and sell peaks. On most occasions, this is less expensive for the external borrower who keeps a static dollar borrowing amount. However, if they never change their dollar leverage amount, there is a chance that, at 1:1 leverage, say, they would be wiped out...like say in the GFC. That would not happen in the internally financed ETF unless the market completed closed. It is for this reason that maintaining a fixed leverage ratio costs expected returns....it protects you against bankruptcy. As mentioned before, you are paying insurance by investing this way. There is no free lunch to be had here for simply saying you'll maintain external leverage vs internal leverage. There is no free lunch to be had just for leveraging without being confident that returns will be high enough to allow for the risk of bankruptcy or the rebalancing costs.

Not straight forward is it?

DeepState said:

Not straight forward is it?

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Definitely not straightforward.

I understand your point now. To leverage means that my view is of capital appreciation, otherwise it would make little sense to gear.

Just to add a little more to the discussion. I've looked into ASX: GEAR and found its annual performance. As you can see, in a situation where the market has been rising, ASX: GEAR has indeed substantially outperformed the market, net of fees/borrowing costs



Also, just to clarify, ASX: GEAR differs markedly from the US products referred to above, which have a 'daily rebalancing' objective. The daily rebalance means that the returns of the products are much more susceptible to what is known as 'path dependency' - which means depending on the path of the returns actual fund returns can vary quite substantially over the course of longer than a day. The ASX: GEAR product uses a wider range (of 90-110%) before any rebalance takes place which will mean that the return are less affected by path dependency.

Great posts DS

For any of those that missed the recent break higher on some of the US indices, the small caps index ETF IWM is still coiling for a breakout. So this might be one to put on your watchlist....

I don't hold currently but will watch....

Wysiwyg said:

Over-rated

I see a lot of raps for ETF's and think they are ideal for set and forget div./dis. investors. Can't see any trading for growth possibility.

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Seems passive investment is all the rage at present. Exchange Traded Funds are where people can park their money for apparent growth over time with no management fees. Everyone happy when the trend is constantly up.

IWM at 147 bucks tracking the Russel 2000 up.

I have a system based on ETFs with a pretty decent backtesting results.
It is base on momentum and volatility The basic idea is to select a group of ETFs and rebalance the basket ones a month based on the momentum and volatility. If somebody is interested I can explain it, and if you use Amibroker I can give you the code.

Is this for the US markets or ASX drequejo?

Lots of info here about rebalancing monthly ETFs.
https://indexswingtrader.blogspot.com.au/

Use on Aussie or US ETFs but the number of US is huge compared to us. Idea is to have a variety that will cover various industries/markets/conditions.

Maybe I haven't found the magic ones on the ASX but for things I tested found US outperformed but not sure why. Thing with the US ETFs (for us) is covering the AUDUSD.