FAQ › Why do you use leveraged ETFs?
Summary: Leveraged ETFs are usually not recommended for long-term investments due to volatility drag and high trading costs. Despite these disadvantages, however, leveraged ETFs represent the easiest way for retail investors to increase their exposure to different markets, including stocks, bonds, and gold. While the additional risk of holding individual leveraged ETFs is beyond the risk tolerance of most investors, holding a well-tuned, diversified portfolio of leveraged ETFs can unlock additional growth potential without additional risk. Barudion's Pro Portfolio provides the methodology to achieve the dynamic diversification that is necessary to make the most out of leveraged ETFs.
Barudions's Pro Portfolio differs from the Free and Basic Portfolio by investing in so-called "leveraged ETFs". Below, we introduce this asset class in detail, describe its pros and cons, and how leveraged ETFs offer a way to outperform the market in the long-term - even though they are not recommended as long-term investments!
ETFs usually are investment vehicles that buy the constituents of certain indices like the S&P 500. This way, an investor does not need the capital and trading expertise to buy 500 different stocks, but can rely on the expertise of the ETF managers and start investing even with very little capital. In the same way, gold ETFs allow investors to get exposure to the gold market without actually buying and storing the precious metal.
Leveraged ETFs differ from "normal" ETFs because they usually do not buy the actual underlying asset (such as stocks or physical gold), but instead they buy financial derivatives (such as futures contracts, options, and swaps). These derivatives allow the ETF to obtain more notional exposure to the underlying market than its invested capital. For example, the daily price fluctuations of a 2x leveraged gold ETF that manages $100M behave as if the ETF had bought $200M worth of gold. More precisely, a 2x leveraged ETF seeks to deliver twice the underlying asset's performance each trading day.
Since most retail investors have no or only limited access to financial derivatives or margin trading, leveraged ETFs often provide the only way to obtain additional exposure to markets, beyond the exposure one could get by buying the asset itself. Below, we will discuss why obtaining additional exposure is important even for long-term investors. Finally, it is important to note that leveraged ETFs have to rebalance their exposure at the end of each trading day (otherwise the fund could easily accumulate a loss that is larger than the managed capital). Because of this rebalancing process, their performance over longer periods can diverge significantly from the targeted multiple—especially in volatile markets. Below, we will discuss this effect in more detail, and argue why leveraged ETFs still represent powerful investment vehicles when used in the right context.
In general, leveraged ETFs are recommended only to sophisticated investors pursuing short-term tactical strategies rather than buy-and-hold portfolios. The main reason why leveraged ETFs are not recommended for long-term investments is an effect called "volatility drag". Since leveraged ETFs have to rebalance their exposure at the end of each trading day, daily returns cannot compound as you would expect from "normal" ETFs. While this rebalancing process is necessary to avoid bankruptcy of the fund, it comes at a cost that is best described with a step-by-step example:
This example nicely illustrates how large up- and down-swings of the underlying asset price (i.e. periods of high volatility) result in additional losses of the leveraged ETF compared to non-leveraged trading and trading on margin. These additional losses are called "volatility drag", and they become larger the more wildly/volatile the underlying market is. An additional disadvantage of many leveraged ETFs is their lower liquidity and higher fees compared to their respective non-leveraged ETFs. Low liquidity often results in larger bid/ask spreads, which in-turn makes trading in and out of those ETFs more costly.
So why should we even bother about leveraged ETFs, if their performance in impaired by volatility drag and their trading costs are high? It is true that leveraged ETFs are quite inefficient investment vehicles, but they still fill an important gap: they provide leverage to anybody, in particular to small investors that do not have access to derivative instruments such as futures and options. Without leverage, the growth potential of your portfolio will always be bounded by the maximal growth rate of your individual investments. For example, if you invest in the S&P 500 and gold, and you correctly predict which asset outperforms the other each quarter, you are still bounded by the highest quarterly return of the two. Using leveraged ETFs, however, you can truly outperform the individual markets. To do that successfully, however, you need a strategy that optimizes the risk-adjusted return of your portfolio, i.e. a strategy that diversifies the risk but also identifies outperforming markets. This is where Barudion's Pro Portfolio comes in!
Our Pro Portfolio is based on the dynamic allocation algorithm that also powers our Basic Portfolio, providing the optimal trade-off between diversification and concentration of capital. While the Basic Portfolio aims at matching the performance of the S&P 500 while reducing the risk, the Pro Portfolio aims at maximizing returns while attaining a risk level that is comparable to the S&P 500. It does by applying two different mechanisms:
It is worth noting that the US version and the EU version of the Pro Portfolio differ in a more pronounced way than the respective versions of the Basic Portfolio. This difference is due to the choice of leveraged ETFs. Since leveraged ETFs are available in greater numbers in the US compared to the EU, we chose the fairly liquid SPUU (2x leveraged S&P 500), UGL (2x leveraged gold), and UBT (2x leveraged 20yr+ Treasury bonds). In the EU, leveraged ETFs are scarce, and the only vendor to offer multiple markets is Wisdom Tree with 3x leveraged ETFs for the S&P 500, gold, and 10yr Treasury bonds. Due to the differences in leverage and the Treasury bond ETFs, the two versions differ in how to weights are calculated and in how much capital they leave unused.
Below, you can see simulations of both versions of the Pro Portfolio, and how they behave under critical market conditions (for example the dot-com bubble, the Great Recession, or the COVID crash). These simulations start before the year 2000, but of course leveraged ETFs are a more recent invention. For time periods during which ETF price data was not yet available, we have created proxy data by using appropriate indices or non-leveraged ETF price data and fitting them to the actual price/return data, incorporating the effect of fees and volatility drag. While these proxy data fit the actual data of the leveraged ETFs very well within the overlapping time period, remember that these simulations still represent approximations.
US Version
The simulation below assumes conservative fees of 0.1% trading costs plus a flat fee of $5 per trade, and updates monthly.
EU Version
The simulation below assumes conservative fees of 0.1% trading costs plus a flat fee of €5 per trade, and updates monthly.
As you can see, the Pro Portfolio stays well diversified most of the time, and but clearly outperforms the S&P 500 during critical market times, when other markets such as bonds or gold shine. To check on the up-to-date performance statistics of all Barudion Portfolios, check out the Performance Section on our landing page.