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Managing Asset Class Exposures with Leveraged ETFs

Posted in Strategic Allocation, Volatility Effects

Are there advantages to using leveraged exchange-traded funds (ETF) to implement conventional asset class exposures? In their October 2018 paper entitled "A Portfolio of Leveraged Exchange Traded Funds", William Trainor, Indudeep Chhachhi and Chris Brown investigate performance of diversified portfolios of 2X or 3X leveraged ETFs that limit exposures to those typically achieved with 1X ETFs. Specifically, when using 2X (3X) funds, allocations are only one half (one third) those for corresponding 1X ETFs. While this approach allows large allocations to a safe asset, it also exposes the portfolio to the higher expense ratios, internal financing costs, leverage decays and rebalancing frequencies of leveraged ETFs. The authors two strategic allocations:

  1. Actual ETFs during 2010-2017 (see the first table below) - 1X portfolio allocations are 30% U.S. large caps, 10% U.S. midcaps, 10% U.S. small caps, 10% non-U.S. developed market stocks, 10% emerging market stocks, 5% real estate investment trusts (REIT), 5% >20-year U.S. Treasuries, 5% 7-year to 10-year U.S. Treasuries and 15% aggregate corporate bonds. "Savings" from holding leveraged ETFs goes to the aggregate bond ETF, for which there are no leveraged counterparts. Rebalancing occurs whenever equities combined deviate from the specified overall levels by more than 10%.
  2. Simulated ETFs during 1946-2017 - 1X portfolio allocations are 50% S&P 500, 10% U.S. midcaps, 10% U.S. smallcaps, 15% >20-year U.S. Treasuries, 15% 7-year to 10-year U.S. Treasuries. An equal-weighted ladder of 1-year, 2-year, 5-year and 7-year U.S. Treasuries. "Savings" from holding leveraged ETFs goes to an equal-weighted ladder of 1-year, 2-year, 5-year, and 7-year treasury bonds.  Rebalancing occurs whenever equities combined deviate from the specified overall level by more than 10%.

Using daily returns for specified ETFs since 2010 and data required to simulate specified ETFs since 1946, all through December 2017, they find that:

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