As retirees relax in their golden years, many fear running out of cash. One recent research paper argues that a small allocation to triple-leveraged exchange traded funds could help augment income generation, but the strategy is not without risks.
Jason Scott, director of the Retiree Research Center at Financial Engines Inc., and John Watson, a Financial Engines colleague and Stanford Graduate School of Business lecturer, published a paper in the Financial Analysts Journal, arguing that for many retirees, a small sampling of leveraged ETFs could benefit an income-generating portfolio, reports Anna Prior for the Wall Street Journal.
Specifically, the theoretical portfolio would follow a “floor-leverage rule” that includes 85% of investments in super-safe, low-risk, income-producing securities like annuities, Treasury inflation-protected securities or other government bonds, along with a 15% allocation to triple-leveraged stock ETFs.
The portfolio will rebalance the 15% allocation in triple-leveraged ETFs if the position grew over the past year, shifting the equity gains into the fixed-income side to help bolster income generation.
“If you want substantial upside but want to be confident that spending won’t run out, this is a strategy that seems to us to make a lot of sense,” Scott said.
However, investors need to understand that leveraged products try to magnify the performance of an underlying index over a daily basis. Consequently, due to the compounding effects, investors may enjoy higher gains in trending markets, such as in 2013, but they must also be willing to accept heavier losses, especially in volatile market conditions. [What Are Leveraged ETFs?]
Compounding can affect leveraged ETFs differently in varying market conditions. For example, in an upward-trending market, compounding can result in long-term returns that are greater than the sum of the individual daily returns, according to ProShares. In a downward-trending market, it can show long-term results that are less negative than the sum of individual daily returns. However, the long-term results are less than the sum of the individual daily returns in volatile market conditions when markets swings are a daily event. [Leveraged ETFs Gain Popularity in Trending Markets]
The Direxion Daily S&P 500 Bull 3X Shares (NYSEArca: SPXL), which generates the daily 300% performance of the S&P 500 Index, gained 118.9% in 2013, more than triple the S&P 500 index returns. However, during volatile conditions, such as in 2011, SPXL saw a negative 14.9% return, whereas the S&P 500 rose 2.1%.
The typical long-term investor should “avoid these things like the plague,” Morningstar fund analyst Michael Rawson, said in the article.
If an advisor or investor is comfortable with the potential risks of leveraged ETFs, he or she should fully understand how the products work.
Many brokerage firms and asset managers have already gotten their hands smacked by regulators after recommending leveraged ETFs without proper education. [Finra Fines Highlight Need for Increased ETF Education]
“The complexity of leveraged and inverse exchange-traded products makes it essential for securities firms and their representatives to understand these products before recommending them to their customers,” Finra chief of enforcement Brad Bennett previously stated.
For more information on geared products, visit our leveraged ETFs category.
Max Chen contributed to this article.