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Using ETFs to Beat the Market with Lower Risk

by: Walid Nasserdeen October 15, 2008 | about stocks: SPY / SSO    

Walid Nasserdeen

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Many  "Tricks of the Trade' are not applicable or even relevant to the normal day to day trader or public investor, but here is an old play with a new spin that anyone can use and appreciate.

You will hear most channels of information say that the level of a fund manager's performance is based on whether he does or does not beat the market. While I do not necessarily agree with this, I will show you how an average investor can consistently beat the market every year  while actually cutting their overall risk by nearly half.

This process use to be done by 'those of the world' with a combination of artistic long positioning, shorting, and leveraging....it also required high levels of capital.... but thanks to recent products (mainly ETFs), the same strategy can be implemented easier, more efficiently, and by any level investor.

Theoretical example of how this works

An investor has 10,000 to invest in the market; the product for this example will be the general S&P.

The S&P trading index is known as a 'Spider' ETF (SPY).

There is also an ETF (SSO) which represents 2x the SPY. It is a 2x leveraged S&P holding, meaning that it moves twice as much as the SPY, whether that be up or down.

...so how do you beat the market every year while cutting your risk by nearly half?

Instead of putting 10,000 in the index, in this case the S&P, put half (5k) in the double leveraged ETF (SSO, for example).

Your 5,000 in the SSO will move as if you had 10,000 in the SPY, but since only half of your capital is in the position, your risk is in essence cut in half (from risking 10k to only 5k).

You then take the remaining 5,000 and put it into a more secure fixed income position (bonds, CDs, savings, etc.) that will add on an estimated 3+% depending on your risk tolerance and product selection.(ex. CD @ 6%).

The higher the interest you make on your fixed income investment, the higher your spread when beating the S&P....but note the higher the interest rate the higher the risk that 5k endures.

Example 1: (simplified) Market Incline

10,000 SPY annual 12% = 11,200

5,000 SSO annual 12%.x2 = 6,200 + (CD)5,000(1.06) = 5,300 = 11,500

Example shows a beating of the market of 3% while reducing risk by nearly half.

Example 2: (simplified) Market Decline

10,000 SPY annual (12%) = 8,800

5,000 SSO annual (12%).x2 = 3,800 + (CD)5,000(1.06) = 5,300 = 9,100

Example shows limited risk and the paring of  losses.

Each index and most sectors have double leveraged ETF available.

Note that beating the market does not mean that you will not lose money. You will simply lose less than the alternate.

One should note that SPY and SSO, as well as any ETF, stock, securities or alternative investment, will posses a level of risk that is not appropriate for all and can result in a loss of investment funds. One should discuss any investment decision with a professional as to understand all the risk involved.

*The following is to be taken as market commentary and general observation. It is in no way to be taken as advice or personal recommendation.

Disclosure: Author is long SSO and has no position in SPY

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This article has 9 comments:

  •  
    Oct 15 09:25 AM
    Wrong, wrong, wrong. A double-leveraged ETF doesn't track the index over the year, but each day. The results over a number of days can diverge wildly from the index. You got the "risk" part right, though.
    Reply
  •  
    Oct 15 09:30 AM
    Better yet buy DOY and on the other side hold some large dividend paying oil stocks. Canadian trusts would be good for this with there big payouts. You collect the big dividends while netting out on the holdings. Safe right?
    Reply
  •  
    Oct 15 10:00 AM
    @Aalan

    You're right of course: The 12 month performance of SPY is down about 35% while SSO is down about 65%. It's up to investors to decide if that's big enough of a difference, I guess.

    The writer's basic idea still holds water to a certain extent, however.
    Reply
  •  
    Oct 15 06:06 PM
    I think the article is gauged, as mentioned, toward the theory of a strategy for non traders and not a correlation of the etfs and indexes.
    Reply
  •  
    Oct 16 11:36 AM
    I am not sure how the original premise makes sense. Ignore for a moment that SSO rebalances leverage daily. If it didn't the investing 5,000 in SSO would create a position of 10,000 long SSO but a borrowing of 5,000 which offsets your additional 5,000 in fixed income. That would be equivalent to 10,000 long SPY except that you now have more fees. It would only produce more if you bought riskier fixed income.

    As was noted, SSO doesn't track 2x SPY. There was a great article in Institutional Investor's ETF Seventh Anniversary publication. Basically, because leveraged funds adjust leverage every day, they do better in trending markets. So if SPY is on a sustained rise, SSO has to upward adjust leverage every day which amplifies returns. Similarly, if SSO is on a sustained fall SSO cuts leverage every day which dampens losses. SSO does worse, however, in range bound markets, because after a down day it lowers leverage, which hurts it when the markets rise the following day, for example.

    So this approach doesn't really reduce short term risk in terms of daily volatility. It will lose you less money in a major crash because of the adjusting of leverage noted above.
    Reply
  •  
    Oct 16 09:33 PM
    I have oft seen this sort of insanity tossed about. It is amazing no one bothers to back test it to see if it works.

    Here are some returns to think about. Open end funds are used to avoid tracking error issues.

    PTTAX Pimco Total Return 5 year annualized 3.96%

    ULPIX Pro Funds UltraBull 5 year annualized -8.24%

    VFINX Vanguard S&P Ind 5 year annualized -0.31%

    From what I can see, you lose more money with leverage and bonds. Leverage costs money, and shouldn't be used unless you know you are right enough to cover the cost.
    Reply
  •  
    Oct 17 05:27 PM
    the article is correct. some are failing to comprehend how the trade is placed. it is long term(3-6month min), rotational, investment best used for retirement and 401k accnts...not a day trade. *jimmys on another page.
    www.marketwatch.com/ne...={28D32D24-AB67-47A4-A...
    Reply
  •  
    Oct 17 08:06 PM
    5 Years isn't long term? The levered fund was down 8% or so while the market was up. What sort of rotation other than correct market timing, selling the levered fund when markets were flat, going down, or overly volitile, would have lead you to outperform?

    Bill, could you point me to a way to put on this trade that did not involve market timing, and leads consistent above market returns?

    I don't dispute the usefulness of levered funds. But they are not long term holds. I bought SSO last Thursday afternoon, and blew out Tuesday morning.

    Another example, this week was very volatile. SSO was up only a very small fraction more than SPY. Nowhere near twice as much. So 5 years, 5 days, a losing strategy. At the same time, I used SSO quite effectively over a three day period recently.
    Reply
  •  
    Oct 27 04:35 PM
    Mr. Nasserdeen was a professor of mine. This is a limited posting on a longer article he wrote in the past so the context may be understandably misunderstood.

    The relevance of the article is in showing the 'theoretical' benefit of using a leveraged ETF while systematically limiting risk. A strategy you could add on to any preexisting strategies you trade by.

    The prominent message is the use of risk management not the relative performance of a leverage ETF.

    The S&P and the correlated SSO are simply used as generic examples for relation. SSO presents itself as a double S&P and therefor is presented as such by the author.

    If the correlation is less than such then simply shifting principal weights from 50/50 to 60/40 or the like, depending on your tolerance, solves any disputes.

    I have used this strategy in the past. It is an alpha primary strategy and is very efficient if used correctly. While 'Jimmy F' is correct in stating that some market timing is involved it is usually assessed quarter to quarter....anything shorter was simply a result of being stopped out.
    Reply
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