This strategy involves a relatively new investment product to the market known as Ultra shares, which mimic the returns of the underlying index times two. The idea behind the Exchanged Traded Fund (ETF) is that if the S&P 500 increases 1%, the ETF will increase 2% and vice versa for a decline. The worry is that people will use these ETFs as a speculative tool and since they are marginable, they can be traded with 4x leverage.
Take for instance a normal ($100,000) portfolio, which is invested in securities that closely follow the S&P 500, so we will use the SPY (SPDR S&P 500 Index Fund):
We purchase 702 shares of SPY @ $142.45 = $100,000
Possible Outcomes:
Market falls 15% = $85,000
Market stays the same = $100,000
Market rises 15% = $115,000
We can simulate this portfolio with the ETF, SSO, offered by Proshares, which is a leveraged S&P 500 ETF. We can purchase $50,000 worth of SSO to create a $100,000 exposure. Here are possible outcomes:
We purchase 576 shares @ $86.75 = $50000
Market falls 15% = $35,000 + $50,000 = $85,000
Market stays the same = $50,000 + $50,000 = $100,000
Market rises 15% = $65,000 + $50,000 = $115,000
What we do with the other $50,000 in the second scenario is the way we will reduce the risk and volatility of investing solely in the stock index and potentially add to its returns. The suggested use of this strategy would be to put part of the $50,000 into a money market or short term treasury bond, and then part of it into a longer term fixed income investment. This is mainly due to the fact that fixed income tends to move opposite of the stock market and if the stock indexes fall, fixed income tends to rise.
For the example we will put the other $50,000 into the following investments:
$35,000 into AGG, which is a Bond ETF that invests over a broad range of bond types and durations, which currently yields 4.70%
$15,000 into a money market account yielding 5.00%
So how would the portfolio look following the recession experienced following 1999?
The following returns of the S&P 500 are from 2000-2002:
2000: -10.14%
2001: -13.4%
2002: -23.37%
A 40% loss was realized following these three years if you had been fully invested in domestic equity. Over these same three years the US Aggregate Index, a bond index, performed as such:
2000: +11.63%
2001: +8.44%
2002: +10.26%
The total bond investment return over these three years was 33.5%. If the investor had been invested in the above portfolio of $50,000 SSO, $35,000 AGG, and $15,000 Money Market from the years 2000 to 2002, the portfolio would look as such:
SSO: $13,683
AGG: $46,725
Money Market @ 5% yield: $17,364
Total Portfolio: $77,772
Total Loss: -$22,228 or -22.2%
If the investor had purely been invested in just the SPY, he then would be down 40% or have a loss of $40,000 and a total portfolio value of $60,000.
The leveraged products available today provide an opportunity for average investors to engage in a greater amount of diversification while adding to returns and reducing the risk associated with market cycles.
This analysis does not take into account commissions and taxes. Happy Investing!
