Flexible Plan's Wagner Uses Leveraged, Inverse ETFs Tactically

Jerry Wagner is president, founder and chief investment officer of Flexible Plan, a turnkey asset management program (TAMP) with more than $1.5 billion invested in its separately managed accounts. He spoke with VettaFi’s Heather Bell about how his firm uses Direxion’s leveraged and inverse ETFs and mutual funds in the strategies it offers to its clients.

Tactical Strategies With Leveraged and Inverse ETFs

How do you generally use leveraged and inverse strategies in your portfolios, whether for mutual funds or ETFs?

We were basically a tactical markets strategist. We would move in and out of a given asset class, usually using trend-following approaches. And it would take us, for example, into stocks and then into money markets and into bonds or back to stocks. In trend following, the trend has to change. And it can take a while for the trend to change. That means you can never buy in at the absolute bottom and you can’t sell out at the absolute top.

But the former is the problem — you can’t buy in at the absolute bottom. You have to wait for that trend to change. When the trend changes, you want to be able to catch up. An ideal way to do that is to make use of a leveraged index product. That was the initial impetus for the Rydex funds, and then the ProShares funds and then the Direxion funds. Those of us who were tactical wanted a way to go back into the market with some leverage to catch up and eventually exceed the performance during favorable market periods.

We still do a lot of tactical strategies — there are about 150 different strategies that we run. But as we expanded over the years, we’ve added more and more strategies and hedged positions as well that aren’t as tactical. They were more looking for the right blend to give yourself a position where there wasn’t an absolute tactical decision; rather, you’re always hedging your bets. We have a number of strategies that do that as well.

Rotating Leveraged Asset Classes

Finally, we have very aggressive strategies where all they do is trade leveraged products, and they just jump from one leveraged product to another. Our “Evolution Plus” strategy moves from a leveraged position in bonds to a leveraged position in stocks to a leveraged position in emerging markets to move anyplace. Having firms like Direxion that have those options makes [strategies like]that possible.

Are you using leveraged and inverse funds in conjunction with each other?

Basically, you can hedge two different ways. You can hedge by becoming more aggressive; in which case, you’re using leverage on top of a 1x position. You don’t want to go to 2x or 3x — you want to go someplace in between to step up the leverage. The same works on the other side. You might have a low-probability buy signal and you’re deeply invested so that you have the chance for capital gains on that position. But you want to hedge against it with the inverse position to protect some of your profits if it goes against you.

The same thing can be done from the tax side. You want to preserve a long-term position in a stock, but you get a sell signal, and rather than getting out of that stock, you do an inverse position against it. Then you’re protecting the profits you built up in that position without selling and incurring taxes

Different Angles on the S&P 500

I know that you use the Direxion Daily S&P 500 Bull 2x Shares (SPUU) and the Direxion Daily S&P 500 Bear 1x Shares (SPDN). Is there a particular way they feature in a portfolio?

That would be the situation I was explaining at the beginning, which is kind of tactical. That would be the first place we would use those — going between a long and a short position tactically. It’s closest to market timing, trying to catch the tops and the bottoms.

We use a 2x inverse or just a plain inverse to hedge the downside. Usually, we’ll only do the 1X inverse. However, we’ll go to the 2x on the leveraged side to enhance returns when we’re fairly confident in our position. But the hedging is a good way to go in most portfolios. It’s amazing, and it doesn’t really hurt to have some portion of it using the short position as a hedge. We’re very active, so we vary that percentage constantly. But we’ll often have the inverse position in a portfolio, along with maybe even a leveraged position. And it’s the net position we’re concerned about.

Mutual Funds Vs. ETFs

I know you use both mutual funds and ETFs. Would you talk about the advantages or disadvantages of the different vehicles?

There’s a time to use mutual funds still, believe it or not. That basically comes down to trading. It’s become less of an issue than it was, but it’s still an issue. ETFs usually have a trading cost associated with them. The difference between mutual funds and ETFs is that mutual funds can be traded without cost. But the mutual funds have a higher internal fee than the ETFs.

The ETF having transaction fees and the mutual fund not having them means if you do trade frequently enough, it shifts the balance. The cost of the transactions can exceed the advantage of the of the lower management fee of the ETF. Then the mutual fund is a better way to go.

There’s also some differences in terms of what what’s available still in the ETFs, as prolific as the ETF strategists have become coming up with new ETFs. But there are still some things that are available in mutual funds that aren’t available in ETFs. If you look at all the leveraged products that are out there in the ETF world, it’s all daily leverage. In other words, it’s computed to get you that leverage on a daily basis.

The Problem With Daily Leverage

That’s also why a lot of leveraged products get attacked. By doing it on a daily basis, given the volatility of the market, post-purchase, you can end up with a final value in your investment that — even though you had the leverage right — really doesn’t work out to [two times the performance of the underlying for a 2x fund]. As a result, when you get to the end, you can even lose money, even though you were on the right side of it just because of the volatility that happens in between.

We came up with a solution that we suggested to Direxion, and they put it into a mutual fund years ago that used an extended time period. Instead of being daily leverage, you were doing it on a monthly basis. And so you ended up where you thought you would [when]holding it for extended periods. I believe they still have a couple of those that we use, for example, Treasury bonds and the Nasdaq-100. That’s another reason you might want to use a mutual fund over an ETF.

Portable Alpha

Are there any other ways to use leverage that you see beyond what you’ve mentioned?

I think one of the things that’s talked about some but [not necessarily that much]is portable alpha. That’s basically being able to use the advantage of leverage to diversify your portfolio into other directions with the remaining portion and still have full exposure to the underlying index. And I think people are waking up to that more and more. I see it getting more press. When I read about it decades ago, it seemed like nobody was talking about it.

But I think today more investors are seeing the advantage of doing that — you don’t have to be just using [leveraged products]for tactical. You can create a portable alpha situation where you have full beta coverage with half of it in a 2x product or with a third with a 3x product. The rest of your cash is still available to use for other investments; for example, high income securities to cover your carrying costs or fees, or going off into commodities or trading some other asset class with the balance.

I think that further diversifies an investor’s portfolio and really maximizes their use of money without the downside that futures can offer, which is [losing]more than what you invest. That downside of futures is scary for a lot of people. You can accomplish the same thing with futures, but you don’t have the limitation of loss that you have with ETFs and mutual funds in the leverage category.

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