300% return on stocks? The dangers of Leveraged Investing

Making 3x returns in Stocks (2/3/18)

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           Growing up, one of the things that most fascinated me was the stock market. Something about Keynes’ animal spirits, the irrational exuberance of investors, and erratic and unpredictable returns appealed to me. It seemed to me that with a surfeit of information I ought to be able to select securities that would perform better than everyone else’s—after all, my sixth-grade simulated portfolio had more than quadrupled in the four years since I reexamined it! Oh, youth.

Perhaps at the heart of my interest is the few lucky trades I made right off the bat—not unlike “beginner’s luck” in gambling, they convinced me that there was money to be made, and I became entranced with the idea that Eugene Fama was wrong (market efficiency theory? Irrelevant!) Perhaps, there exists enough asymmetric information such that a privileged and knowledgeable individual (a portfolio manager, for example) could wade through the noise and locate the signal of a deeper lying trend, uncovering mis-priced securities. Inside Traders, for example, consistently make a tidy profit. Unfortunately, such results could not be replicated by 99.9% of us. Millennial investors get a bad rap—we are more ethically conscious than our predecessors and certainly make a concerted effort to save for the future—but many of the views we hold are intrinsically contradictory (for example, a desire for a strong dollar, and a trade surplus). A few of the problems I see in young investors are unwilling assumption of excess risk, a lack of a clear exit strategy, and a belief that the markets can be timed accurately. I’ve been privy to these myself at times, but would like to spend time writing about the Leveraged ETF (which aims for 2-3 times index returns), and whether or not it's a good investment option.

Stocks are evaluated on a risk-return basis, which is typically measured in standard deviations from the expected return (E(x)) of the security. ETF’s, or exchange-traded funds, work similarly, but are managed for a nominal fee and provide exposure to a broad swath of asset classes, offering instant diversification. Such funds can be found in other funds, market indexes, foreign assets, commodities, and a wide variety of other assets, with fluctuating fees based on the frequency of the need for re-balancing. Vanguard’s S&P 500 index, for example, has expenses of only 0.14% annually, far less than the historical load of a managed mutual fund. In the long run, the S&P returns about 8% annually, or 5-6% adjusted for inflation (and including dividends). A leveraged ETF would then in theory provide an investor with a 16-24% return. Given the power of compounding, why would such an investment not appeal to all investors, let alone millennials? The return since the inception of Direxion’s Large Cap Bull ETF (3X leverage) is right around 90% per year, up some 700%!

Unfortunately, any data we have is necessarily backwards-looking. Even Value at Risk (VaR) models subscribe to this logical fallacy, meaning that systemic, or broader-market risk, is the same towards the end of the bull market (right now) as it would have been immediately after the crash (2008) in many models. Likewise, with a conception in 2012, the Direxion fund (SPXL, NYSE) has been fortunate enough to exist in a bull market with very few significant corrections. Although the S&P will march upwards in the long run, the difficulty of timing markets makes such investments unattractive. Should the S&P correct 5% from current levels, and then rally to its previous close, it would be a break-even investment. The mirroring leveraged fund would not—it would correct 15%, recover 15.8%, and end up 1.6% lower than before, despite no net change in the greater market. In short, as an investor you must be careful to evaluate potential risks and returns in such speculative securities, and know what you’re getting yourself into. The best tip I’ve heard is not to invest anything you’re not able and willing to lose—if you want to try to time the market, there are intelligent ways to do so, but the risk of a sideways market or unexpected correction can never be completely mitigated. Even the best investors struggle to predict market trends. For the casual investor, a long-term buy and hold index fund seems to consistently outperform active models. Hope this helps!