With the low interest rates, everybody has become Beta chasers and a lot of ETF has opened up to encash on this opportunity. The idea being with interest being low/zero & stock market expected to generate positive return over a long term. Higher the beta, better will be the returns. However, is it wise for long term?
Take the case of SPXL which delivers 3X returns (positive or negative) compared to the underlying S&P. On a daily basis, their ability to track consistently has been stellar, yet on an annual/5 year term, they have been underperforming . For example over the last 12 months S&P is down by 2.83% but SPXL is down 12.44% or 4.4 times the loss instead of expected 3X.
Couple of reasons for this drift:
- The effects of volatility & compounding. Do a simple calculation If S&P goes up by 10%, you would expect Direxion Daily S&P 500 Bull 3X to go up by 3*10% or your $100 become $130. However due to volatility if S&P goes down by 9% (or back to same level) your $130 will do down by 27% and become $94.5/-. Even assuming that these high swings don’t often daily, but small swings (up down movement) that happen every day over the year will definitely eat into your savings. This is the reason why on a flat volatile market these funds will under-perform. Here is an illustration from the fund manager explaining the effect of daily volatility on the annual yield that this fund will deliver. Essentially one can expect to lose 17% of the fund value if the S&P return is zero and volatility is 25% (2015 volatility was avg of 14.28%) You can find more details at this NASDAQ link. Essentially there is no free lunch, high beta comes with its own cost & challenges. But in my opinion, buying derivatives directly is always cheaper than getting funds buy it on your behalf.
- Expense ratio which is 0.95% per annum compared to 0.05% for S&P index funds.
- Due to daily rebalancing, there is very high turnover (254% of average portfolio value). The transaction cost & bid-ask spread do eat into your profits.
- To achieve a 3X return, the fund needs to invest into derivative products and buy other funds on margin. This not only adds a leverage cost but also has a roll over expense when one contract expires and new one needs to be purchased.
- Also remember this is a fund of funds. Instead of buying the underlying assets the fund buys swaps, other ETF, index funds & treasury/liquid instruments. Each of which has its own cost which adds up to the overall expense that the long term investor ends up paying.
Some of the ETF also have an option to short (get negative beta). Now this might be good when part of a portfolio or for opportunistic short term trades. But in the long term this might not be a viable strategy.