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Leveraged ETFs, A More Realistic Test

risky (2)A previous article looked at the results of trading 2X Leveraged ETFs by themselves. The backtest results were poor to horrendous.

However, to be fair, that test is not representative of the way most people use leveraged ETFs.  Leveraged ETFs, if they are to be used at all, should only be used in the context of a broader trading strategy and for short time periods. Using them exclusively is too risky and a practice that no one that I am aware of would advocate. Indeed, doing so is a sure way to go bust!

There are many reasons to steer clear of leveraged ETFs. Lorimer Wilson, using an article by Louis Baseness provides these. A quote from the article follows:

Beneath a simple exterior – and the allure of a novel hedging strategy – there are considerable complexities and risks associated with leveraged ETFs.

Unless you’re a day trader, with an uncanny ability to predict every jot and tittle of the market, avoid leveraged ETFs like the plague.  Heck, even if you could pull off such a feat, the transaction costs would eat your portfolio alive, so the best bet is to simply avoid leveraged ETFs altogether.

Anyone considering leveraged ETFs should read this article.

Testing Leveraged ETFs Within The Context of A Broader Trading Strategy

A better test for whether leveraged ETFs have value in a trading plan is to utilize them in conjunction with a defined strategy of trading. One way of judging their effectiveness is to compare them to a portfolio of non-leveraged ETFs. In our case, what would leveraged ETFs do to the performance of one of the momentum-volatility portfolios regularly monitored?

Let’s take a look at backtesting results for the large US portfolio.

Regular US(6) Portfolio

The monthly selections from the US pool come from 48 ETFs. Up to six are selected by the ranking algorithm each month.

For the period Jan 1, 2007 through June 28, 2013, backtest results produced a total return of 134%. This compared with the benchmark, SPY, of 30% for the same period. The maximum drawdown was 17% compared to SPY of 55%. Backtested returns by year are shown below. The six-stock portfolio outperformed SPY 54% of the time. Volatility was 17% versus SPY of 22%.  There was only one month where there was a gain/loss exceeding 10%.

Relative Strength Backtest  US(6)

Aggressive Leveraged Portfolio

The addition of two 2X leveraged long pools to the US stocks raised the pool of ETFs to 61. Selecting only two ETFs each month raised the full period return to 169% versus a SPY return of 30%. The maximum drawdown was 21% versus SPY of 55%. The purpose of selecting only two ETFs rather than six or eight was to minimize the selection possibilities of the leveraged ETFs.

Backtested returns by year are shown below. Only two selections were made per month. The two-stock portfolio outperformed SPY 56% of the time. Volatility was 22%. In six of the months, gains or losses for the month were in double digits. The two most used leveraged ETFs were UST and ROM which were held for 171 and 83 trading days respectively of the 1634 trading days in the time frame.

Relative Strength Backtest   Combine Portfolios

Expanded Selections

Using the same pool of stocks as above, but selecting 8 ETFs per month produced a return of 166%. and a drawdown of 19%. The eight-stock portfolio outperformed SPY 60% of the time. Volatility was 22%. In only two of the months were the gains/losses in double digits. Many of the leveraged ETFs were held for more than 200 trading days (although not necessarily consecutive days) with some of the leveraged commodity funds among the leaders (remember, most of this period saw rapid run-ups in precious metals).

Expanded Selections To Include Inverse Leveraged ETFs

This backtest was the same as the one immediately above except that 2X Leveraged Short ETFs were all added to the pool, bringing the number in the pool up to 73. Eight ETFs were selected each month.  The return for the full period was 119% and the drawdown was 21%. Volatility was 20%. The selections outperformed SPY 55% of the time. Three of the monthly periods showed gains/losses in excess of 10%. The selection of Short ETFs was relatively small, but enough to knock down the results in a period of generally rising markets.

Conclusion

Based on a small study, leveraged ETFs may have some use in a momentum-volatility based trading strategy. The volatility screen appears to limit their selections in a manner that can be useful. Despite this small sample, all of the negatives explained in the referenced article above still remain. Leveraged ETFs are dangerous to your financial wealth.

Many Premium Members have no interest in exposure to leveraged ETFs. A minority do.

Further investigation will be done. Should leveraged ETFs be determined to be useful, they will be incorporated into the momentum-volatility service. If they are, they will be segregated from the existing selection process(es). That is, they will be an option for those who want to use them. Members who prefer to avoid them may continue to do so. Current selections will not be affected.

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