Levered ETFs for the Long Run?

January 8, 2018

S UMMARY

• We believe that capital efficiency should remain a paramount objective for investors.

• The prudent use of leverage can help investors employ more risk efficient portfolios without necessarily
sacrificing potential returns.

• Many investors, however, do not have access to leverage (be it via borrowing or derivatives). They may,
however, have access to leverage via Levered ETFs.

• Levered ETFs are often dismissed as trading vehicles, not suited for buy-and-hold investors due to the so-called
“volatility drag.” We show that the volatility drag is a component of all compounding returns, whether they are
levered or not.

• We explore the impact that the reset period can have on Levered ETFs and demonstrate how these ETFs may
be used in the context of a portfolio to introduce diversifying, alternative exposures.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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About Newfound Research

Founded in August 2008, Newfound Research is a quantitative asset management firm based in Boston, MA.

Investing at the intersection of quantitative and behavioral finance, Newfound Research is dedicated to helping investors
achieve their long-term goals with research-driven, quantitatively-managed portfolios, while simultaneously
acknowledging that the quality of the journey is just as important as the destination.

We work exclusively with financial advisors and institutions to help them manage the wealth of their clients through our
suite of investment portfolios and mutual funds.

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Our strategies reflect our view that investing is not easy. Emotional decisions can derail even the best laid
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with. Research shows that investors feel the pain of losses more than they feel the joy of gains. This is reflected in a
deep desire to protect the capital that they have worked hard to accumulate. Accordingly, we seek to improve risk-
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Our portfolios are available as separately managed accounts, through model manager platforms, and as mutual funds1.

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1
See http://www.thinknewfoundfunds.com
2
See http://www.thinknewfound.com/qube-managed-portfolios
3
An ETF Strategist is a firm that builds portfolios primarily using exchange-traded funds.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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Early last month, we published a piece titled Portable Beta: Making the Most of the Returns You’re Already Getting4, in
which we outlined an argument whereby investors should focus on capital efficiency. We laid out four ways in which we
believe that investors can achieve greater efficiency:

1. Reduce fees to take home more of what you earn.

2. Express active views more purely so that we are not caught paying active management prices for closet beta.
3. Focus on risk management by “diversifying your diversifiers” with strategies like trend following that can help
increase exposure to higher return asset classes without necessarily increasing the overall portfolio risk profile.
4. Utilize modest leverage so that investors can create more risk-efficient portfolios without necessarily sacrificing
potential return.

Unfortunately, for many investors, access to true leverage – either through borrowing or the use of derivatives – may be
beyond their means. Fortunately, there are a number of ETFs available today that allow investors to access leverage in a
packaged manner.

Wait, Aren’t Levered ETFs Dangerous?

Levered ETFs have quite a reputation, and not a good one at that. A quick search will result in numerous articles that tell
you why they are a dangerous, bad idea. They are pejoratively dismissed as “trading vehicles,” unsuitable for “buy and
hold.”

Most often, the negative publicity hinges on the concept of volatility decay (or, sometimes “volatility drag”). To illuminate
this concept, let’s assume there is a stock that can only go up either +X% or down –X%. Thus, in any two-day period,
we have the following growth in our wealth:

Up Down

Up (1 + X%)(1 + X%) (1 - X%)(1 + X%)

Down (1 + X%)(1 – X%) (1 – X%)(1 – X%)

If we expand out the returns, we are left with:

Up Down

Up 1 + 2X% + X%2 1 - X%2

Down 1 - X%2 1 - 2X% + X%2

4
https://blog.thinknewfound.com/2017/12/portable-beta-making-returns-youre-already-getting/

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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Note that in the case where the stock went up +X% and then down -X% (or down –X% and then up +X%), we did not
end up back at our starting wealth. Rather, we ended up with a loss of -X%2.

On the other hand, we can see that when the stock goes the same direction, we actually outperform twice the daily
return by +X%2.

What’s going on here?

It is nothing more than the math of compound returns. The returns of the second day compound the returns of the first.

The effect earns the moniker volatility decay because in return environments that are mean-reversionary (e.g. positive
returns follow negative returns, and vice versa), our capital decays due to the -X%2 term.

Note, however, that we haven’t even introduced leverage into the scenario yet. This drag is not unique to levered ETFs:
it is just the math of compounding returns. Why it gets brought up so frequently with respect to levered ETFs is because
the leverage can accentuate it. Consider what happens if we introduce a daily leverage factor of L:

Up Down

Up 1 + 2LX% + L2X%2 1 - L2X%2

Down 1 - L2X%2 1 – 2LX% + L2X%2

When L=1, we have a standard long-only investment. When L=2, we have our 2X daily levered ETFs. What we see is
that when L=1, our drag is simply –X%2. When L=2, however, our drag is 4X%2. When L=3, the drag skyrockets to
9X%2. Of course, the so-called drag turns into a benefit in trending markets (whether positive or negative).

So why do we not see this same effect when we use traditional leverage? After all, are these ETFs not using leverage
under the hood to achieve their returns?

The answer lies in the daily reset. Note that these ETFs aim to give you a multiple of returns every day. The same is not
true if we simply lever our notional exposure and never reset it. By “reset,” we mean pay back what we owe and re-
borrow capital in order to maintain our leverage ratio.

To achieve 2X daily returns, the levered ETFs basically borrow their NAV, invest in the asset class, and then pay back
what they borrowed. Hence, every day they reset how much they borrow.

If we never reset, however, the proportion of our capital that is levered varies over time. Consider, for example, investing
$10,000 of our own capital in the SPDR S&P 500 ETF and borrowing another $10,000 to invest alongside (for
convenience, we’re going to assume zero borrowing cost). As the market has gone up over time, the initial $10,000
borrowed becomes a smaller and smaller proportion of our capital.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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Source: CSI. Calculations by Newfound Research. Assumes portfolio applies 100% notional leverage applied to SPDR
S&P 500 ETF (“SPY”) at inception of ETF. Assumes zero cost of leverage.

This happens because while we owe the initial $10,000 back, the returns made on that $10,000 are ours to keep. In the
beginning, our portfolio will behave very much like a 2X daily levered ETF. As the market trends upward over time,
however, we not only compound our own capital, but compound our gains on the levered capital. This causes our
actual leverage to decline over time. As a result, our daily returns will gradually converge towards that of the market.

In practice, of course, there would be a cost associated with borrowing the $10,000. However, the same fact pattern
applies so long as the growth of the portfolio exceeds the cost of leverage.

Resetting, therefore, is a necessary component of maintaining leverage. On the one hand, we have daily resets, which
keeps our leverage proportion constant. On the other hand, we have “never reset,” which will decay the leverage
proportion over time (assuming the portfolio grows faster than the cost of leverage). There are, of course, shades of gray
as well. Consider a 1-year reset:

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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Source: CSI. Calculations by Newfound Research. Assumes portfolio applies 100% notional leverage applied to SPDR
S&P 500 ETF (“SPY”) at inception of ETF and reset every 252-days thereafter. Assumes zero cost of leverage.

Note that in 2008, the debt proportion of our balance sheet spiked up to nearly 90% of our capital. What happened?
This is reset timing risk. On 4/2008, the portfolio reset, borrowing $92,574 against our equity of $92,574. Over the next
year, the market fell approximately 39%. Our total assets tumbled from $185,148 to $114,753 and we still owed the
initial $92,574 we borrowed. Thus, our actual equity over this period fell an astounding -76.7%.

(It is worth pointing out that if we had considered a “never reset” portfolio that started on 4/2008, we’d have the same
result.)

Frequent readers of our commentary may be wondering, “can this reset timing risk be controlled with overlapping
portfolios just like other timing risks?” Yes … ish. On the one hand, there is not a whole lot we can do about the
drawdown itself: 100% notional leverage plus a 37% drawdown means you’re going to have a bad time. Where
overlapping portfolios can help is in ensuring that resets do not necessarily occur at the worst possible point (e.g. the
bottom of the drawdown) and lock in losses.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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As a general rule, we probably don’t want to apply N-times exposure over a time frame an asset class can experience a
return of -1/N%. For example, if we want 2x equity exposure, we want to make sure we reset our leverage exposure
well before equities have a chance to lose 50% (1/2). Similarly, if we want 3x exposure, we need to reset well before we
can lose 33.3% (1/3).

So, Are They Evil or What?

We would argue that volatility decay takes the blame when it is not actually the culprit. Volatility decay is nothing more
than the math of compounding returns: it happens whether you are levered or not.

The danger of most levered ETFs is more easily explained. If I told you I was going to take your investment, use it as
collateral to gain 100% notional exposure to equities, and then invest that collateral in equities as well – an asset class
than can easily lose 50% –what would you say? When put that way, it sounds a little nuts. It really isn’t much more
complicated than that.

The reset effect really just introduces a few more nuanced wrinkles. The more frequently we reset, the less risk we run of
going bust, as we take risk off the table as our debt-to-equity ratio climbs. That’s how we can avoid complete ruin with
100% leverage in an asset class that falls more than 50%.

On the other hand, the more frequently we reset, the closer we keep the portfolio to the target volatility level, increasing
the drag from short-term mean reversion.

We’ve said it before and we’ll say it again: risk cannot be destroyed, only transformed.

But, these things might have their use yet…

Levered ETFs in a Portfolio

Held as 100% of our wealth, a 2X daily reset equity ETF may not be too prudent. In the context of a portfolio, however,
things change.

Consider, for example, using 50% of our capital to invest in a 2x equity exposure and the remaining 50% to invest in
bonds. In effect, we have created 150% exposure to a 67/33 stock/bond mixture. For example, we could hold 50% of
our capital in the ProShares Ultra S&P 500 ETF (“SSO”) and 50% in the iShares Core U.S. Bond ETF (“AGG”).

To understand the portfolio exposure, we have to look under the hood. What we really have, in aggregate, is: 100%
equity exposure and 50% bond exposure. To get to 150% total notional exposure, we have to borrow an amount equal
to 50% of our starting capital. Indeed, at the portfolio level, we cannot differentiate whether we are using that 50%
borrowing to lever up stocks, bonds, or the entire mixture!

In this context, levered ETFs become a lot more interesting.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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The risk, of course, is in the resets. To really do this, we’d have to rebalance our portfolio back to a 50/50 mix of the 2x
levered equity exposure and bonds on a daily basis. If we could achieve that, we’d have built a daily reset 1.5x 66/33
portfolio.

More realistically, investors may be able to rebalance their portfolio quarterly. How far does that deviate from the daily
rebalance? We plot the two below.

Growth of $1
$4.50

$4.00

$3.50

$3.00

$2.50

$2.00

$1.50

$1.00

$0.50

Daily Rebalance Quarterly Rebalance SPY AGG

Source: CSI. Calculations by Newfound Research. Returns for the Daily Rebalance and Quarterly Rebalance portfolios
are backtested and hypothetical. Returns are gross of all fees except underlying ETF expense ratios. Returns assume
the reinvestment of all distributions. Cost of leverage is assumed to be equal to the return of a 1-3 Year U.S. Treasury
ETF (“SHY”). Past performance is not indicative of future results. The Daily Rebalance portfolio assumes 50% exposure
to a hypothetical index providing 2x daily exposure of the SPDR S&P 500 ETF (“SPY”) and 50% exposure to the iShares
US Core Bond ETF (“AGG”) and is rebalanced daily. The Quarterly Rebalance portfolio assumes the same exposure, but
rebalances quarterly.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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Indeed, for aggressive investors, a levered equity ETF mixed with bond exposure may not be such a bad idea after all.
However – and to steal a line from our friends at Toroso Asset Management5 – levered ETFs are likely “buy-and-adjust”
vehicles, not buy-and-hold. The frequency of adjusting, and the cost of doing so, will play an important role in results.

A Particular Application with Alternatives

Where levered ETFs may be particularly interesting is in the context of liquid alternatives.

In the past, we have said that many liquid alternatives, especially those offered as ETFs, have a volatility problem.
Namely, they just don’t have enough volatility to be interesting.

Traditionally, allocating to a liquid alternative requires us removing capital from one investment to “make room” in our
portfolio, which creates an implicit hurdle rate. If, for example, we sell a 5% allocation of our equity portfolio to make
room for a merger arbitrage strategy, not only do we have to expect that the strategy can create alpha beyond its fees,
but it also has to be able to deliver a long-term return that is at least in the same neighborhood of the equity risk
premium. Otherwise, we should be prepared to sacrifice return for the benefit of diversification.

One solution to this problem with lower volatility alternatives is to fund their allocation by selling bonds instead of stocks.
Bonds, however, are often our stable ballast in the portfolio. Regardless of how poorly we expect core fixed income to
perform over the next decade, we have a high degree of certainty in their return. Asking us to sell bonds to buy
alternatives is often asking us to throw certainty out the window.

By way of example, consider the Reality Shares DIVS ETF (“DIVY”). We wrote about this ETF back in August 20166 and
think it is a particularly compelling story. The ETF buys the floating leg of dividend swaps, which in theory captures a
premium from investors who want to insure their dividend growth exposure in the S&P 500.

For example, if the swap is priced such that the expected growth rate of S&P 500 dividends is 5% over the next year,
but the realized growth is 6%, then the floating leg keeps the extra 1%. The “insurance” aspect comes in during years
where realized growth is below the expected rate, and the floating leg has to cover the difference. To provide this
insurance, the floating leg demands a premium.

A dividend swap of infinite length should, in theory, converge to the equity risk premium. Short-term dividend swaps
(e.g. 1-year), however, seem to exhibit a potentially unique risk premium, making them an interesting diversifier within a
portfolio.

While DIVY has performed well since inception, finding a place for it in a portfolio can be difficult. With low volatility, we
have two problems. First, for the fund to make a meaningful difference, we need to make sure that our allocation is large
enough. Second, we likely have to slot DIVY in for a low volatility asset – like core fixed income – so that we make sure
that we are not creating an unreasonable hurdle rate for the fund.

5
http://torosoam.com/inverse-etfs-help-avoid-margin-accounts-tread-cautiously/
6
https://blog.thinknewfound.com/2016/08/can-dividend-swaps-replace-bonds/

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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Levered ETFs may allow us to have our cake and eat it too.

For example, ProShares offers an Ultra 7-10 Year Treasury ETF (“UST”), which provides investors with 2x daily return
exposure to a 7-10 year U.S. Treasury portfolio. For investors who hold a large portfolio of intermediate-term U.S.
Treasuries, they could potentially sell some exposure and replace it with 50% UST and 50% DIVY.

As before, the question of “when to reset” arises: but even with a quarterly rebalance, we think it is a compelling
concept.

Hypothetical Growth of $1
$2.00

$1.80

$1.60

$1.40

$1.20

$1.00

$0.80

$0.60

S&P 500 Dividend Swaps Index

iShares 7-10 Year US Treasury ETF ("IEF")
50% 2x Daily 7-10 Year U.S. Treasury Index / 50% S&P 500 Dividend Swaps

Source: CSI. Calculations by Newfound Research. Returns for the S&P 500 Dividend Swaps Index and 50% 2x Daily 7-
10 Year US Treasuries / 50% Dividend Swap Index portfolios are hypothetical and backtested. Returns are gross of all
fees except underlying ETF expense ratios. Returns assume the reinvestment of all distributions. Cost of leverage is
assumed to be equal to the return of a 1-3 Year U.S. Treasury ETF (“SHY”). Past performance is not indicative of future
results. The 50% 2x Daily 7-10 Year US Treasuries / 50% Dividend Swap Index assumes a quarterly rebalance.

Conclusion

Leverage is a tool. When used prudently, it can help investors potentially achieve much more risk-efficient returns.
When used without care, it can lead to complete ruin.

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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For many investors who do not have access to traditional means of leverage, levered ETFs represent one potential
opportunity. While branded as a “trading vehicle” instead of a buy-and-hold exposure, we believe that if prudently
monitored, levered ETFs can be used to help free up capital within a portfolio to introduce diversifying exposures.

Beyond the leverage itself, the daily reset process can introduce risk. While it helps maintain the leverage ratio -
– reducing risk after losses – it also re-ups our risk after gains and generally will increase long-term volatility drag from
mean reversion.

This daily reset means that when used in a portfolio context, we should, ideally, be resetting our entire portfolio daily. In
practice, this is impossible (and likely imprudent, once costs are introduced) for many investors. Thus, we introduce
some tracking error within the portfolio.

We should note that there are monthly-reset leverage products that may partially alleviate this problem. For example,
PowerShares and ETRACS offer monthly reset products and iPath offers “no reset” leverage ETNs that simply apply a
leverage level at inception and never reset until the ETN matures.

Perhaps the most glaring absence in this commentary has been a discussion of fees. Levered ETP fees vary wildly,
ranging from as low as 0.35% to as high as 0.95%. When considering using a levered ETP in a portfolio context, this fee
must be added to our hurdle rate. For example, if our choice is between just holding the iShares 7-10 Year U.S.
Treasury ETF (“IEF”) at 0.15%, or 50% in the ProShares Ultra 7-10 Year Treasury ETF (“UST”) and 50% in the Reality
Shares DIVS ETF (“DIVY”) for a combined cost of 0.93%, the extra 0.78% fee needs to be added to our hurdle rate
calculation.

Nevertheless, as fee compression marches on, we would expect fees in levered ETFs to come down over time as well,
potentially making these products interesting for more than just expressing short-term trading views.

Corey Hoffstein & Justin Sibears

Newfound Research LLC | 425 Boylston Street, 3rd Floor | Boston, MA 02116 | p: 617-531-9773 | w: thinknewfound.com
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About Newfound Research

Investing at the intersection of quantitative and behavioral finance, Newfound Research is dedicated to helping clients
achieve their long-term goals with research-driven, quantitatively-managed portfolios, while simultaneously
acknowledging that the quality of the journey is just as important as the destination.

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