Let’s look at being right. The early 80s were a good time to lever up bonds – but we are no longer in the early 1980s. Rates are historically very low, and the probability of a long bull market in fixed income is now not good. Since equities have historically gone up over long stretches of time, it probably makes the most sense to invest levered in equities, especially a broad index like the S&P 500 where your risk of one day ruin is smaller.
Since it’s hard to have impeccable timing, the best you can do is invest ONLY after there has been a decent correction, though even this is no guarantee of profitability. If you invested in a 3x levered S&P 500 ETF in 2002, you were still down a decade later, because of the 2008 crash. But, getting in when stocks are close to new highs has been an even less profitable way to invest in levered equity ETFs.
Which leaves patience. The average 10 year return for a hypothetical 3x levered S&P 500 ETF since 1950 has been 582%. Nice. This return comes with the caveat that most of this average is skewed by the outlier returns you would have experienced in the late 1990s. There were also 10 year periods where you lost over -96% of your investment. Ouch.
It’s only when you move to a 20-year time horizon that historically our hypothetical 3x levered S&P 500 ETF has provided positive expected returns, irrespective of when you invested. At 20 years, which is a long time, your worst 20-year return was +15%. Contrast this with an unlevered investment in the S&P 500 where your worst 20-year return was +53.8%. In a contrast of worst case scenarios, the unlevered version wins.
Now consider median results. Your median return was 699% levered vs. 274% unlevered. So it seems like the levered version is better. But, again all of this was skewed by the 50,000+% return from the 1980s and 90s bull market. That’s one event severely skewing the average. And that event was driven by a huge decline in interest rates from very high levels. If interest rates get high enough again, a 20-year levered bet on equities might make sense, but until then, probably not.
I know what you’re thinking. 50,000+%?!?! Like I said, every time I pull up a levered ETF or ETN to review I get the same sensation as walking into a Vegas casino…
Kent Peterson, PhD (author of the blog: Insights from a Quant)
Chris Shuba
Helios Quantitative Research, LLC
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