For any investor who holds oil and natural gas stocks in their portfolio, the movement of those stocks is typically tied to the underlying commodity, not to the broader markets. Investing in energy stocks does not come without sharp volatility that may keep small investors on their toes and awake at night, but with the introduction of new Exchange Traded Fund products, investors now have a way to keep the overall movement to a minimum.

The idea behind the strategy is that an investor has a long exposure to oil and natural gas companies and hedges that exposure with a short position in an oil or natural gas commodity ETF. For example:

An investor has a $50,000 long exposure to oil companies and $25,000 long exposure to natural gas companies. To hedge his investment, the investor would sell short $50,000 of an oil commodity ETF, such as the iPath S&P GSCI Crude Oil Tot Ret Idx ETN (OIL), U.S. Oil Fund ETF (USO), Claymore MACROshares Oil Up Tradeable Tr (UCR) or PowerShares DB Oil Fund (DBO), and then sell short $25,000 of the United States Natural Gas ETF (UNG). This effectively gives the investor a neutral exposure to underlying commodity movements, while still enjoying the value added feature of investing in quality oil and natural gas companies, such as buybacks and dividends.

On July 31, 2007, I initiated the following demo trades as a test to this strategy:

As of August 31, 2007, the strategy has returned a profit of 5.74% versus a .94% return of holding only the two oil and natural gas stocks, Valero Energy Corp. (VLO) and Nicor Inc. (GAS), over the month. The majority of the profit came from the short position in the United States Natural Gas Fund (UNG), which benefited from a decline in the price of natural gas over the past month.

Although the proposed investment strategy does not fully hedge a portfolio against macroeconomic and firm specific risks, it does significantly lower the volatility that comes with investing in oil and natural gas companies. This strategy also allows investors to take advantage of an inflated commodity price and with oil trading towards its 52 week high this week, investors may choose to use this strategy to lock in that price.

Disclosure: The author does not hold any positions in securities mentioned in this article.

All testing was done through Stockalicious.com, the performance of the above strategy can be viewed by visiting http://stockalicious.com/stock_journal/1190

Most investors are familiar with the fact that most Closed-end Funds (CEFs) trade at a discount to Net Asset Value (NAV) and carry an above average dividend, but are unsure of how to profit from these variables.

There is also a relatively new investment product known as Leveraged Exchange Traded Funds (ETFs), which seek to double the daily returns of a specific index. There are leveraged ETF products for every general sector in the market as well as the broad indexes. There also are leveraged ETF products that move opposite to the underlying index.

An investor can utilize both of these products to generate income similar to that of a fixed income instrument, but this strategy has much less volatility. By implementing this strategy, an investor takes advantage of the above-average dividends that the Closed-end Funds provide and virtually eliminates the risk of the transaction using a leveraged ETF that moves in the opposite direction of the index that the CEFs follow.

The Closed-end Funds used in this analysis made investments in Real Estate Investment Trusts (REITs). The portfolio strategy is based off the investor purchasing a set amount of CEF REITs and simultaneously buying half that amount of the ProShares UltraShort Real Estate ETF (SRS). Below is a breakdown of the model portfolio (Please click on the picture for a pop-up of the portfolio in a much clearer format):

The Funds used in the portfolio are as follows:
SRS – Proshares UltraShort Real Estate ETF
SRQ – DWS RREEF Real Estate Fund
SRO – DWS RREEF Real Estate Fund II
NRO – Neuberger Berman Real Estate Securities Income Fund
RTU – Cohen & Steers REIT & Utility Income Fund
RQI – Cohen & Steers Quality Income Realty Fund
RMR – RMR Real Estate Fund

In this case, using the CEF REITs and ProShares UltraShort Real Estate ETF creates a portfolio that is market neutral and set up to make roughly 6.856% a year in dividend income. The portfolio also has the possibility of generating additional return by closing the gap of each fund’s discount to NAV, which currently averages 6.982% for the portfolio.The variability of the portfolio should be minimal because any market movement would have a negligible effect on the portfolio. However, there are some risks involved. One of the risks that could affect the portfolio’s health is the individual management of the closed-end funds and/or any changes to dividend policies. An additional risk is that the portfolio relies on an expectation that the leveraged ETF will double the overall movement of the index; but since the leveraged ETF is marketed to double the daily return, the compounding effect could be a significant factor in how much the investor profits from the portfolio.

The income factor makes this model portfolio extremely attractive, as does the opportunity to receive some capital gains from the movement of the Closed-end Funds towards their NAV. Though IRA accounts are usually long-only positions, this investment could work well in an account such as that. Furthermore, it would be advisable to perform this trade in a tax-free account, such as an IRA because the distributions made by the Closed-end Funds do not fall under the favorable dividend tax laws, since REITs are required to pay out 90% of their taxable income as distributions. If a trader chooses to perform this trade in a taxable account, then it would be worthwhile to hire a tax accountant to look at any tax consequences to this trade.

Over the past couple years Exchange-Traded Funds have been popping up quickly; first they appeared in the general areas of the market, and now they are moving into the niche markets. In the past year, Rydex has introduced eight new ETFs, known as CurrencyShares, into the market. These ETFs focus purely on currency.

• CurrencyShares Euro Trust (Ticker: FXE)
• CurrencyShares Mexican Peso Trust (Ticker: FXM)
• CurrencyShares Swedish Krona Trust (Ticker: FXS)
• CurrencyShares Australian Dollar Trust (Ticker: FXA)
• CurrencyShares British Pound Trust (Ticker: FXB)
• CurrencyShares Canadian Dollar Trust (Ticker: FXC)
• CurrencyShares Swiss Franc Trust (Ticker: FXF)
• CurrencyShares Japanese Yen Trust (Ticker: FXY):

According to the Rydex Prospectuses, the ETFs allow investors to buy into a trust denominated in the particular currency that bears interest according to that currency’s particular interest rate.

These funds seem to hit the market at the perfect time—right at the turning point of further US Dollar depreciation. In the year and a half since the introduction of the CurrencyShares Euro ETF (FXE), the US dollar has depreciated roughly 13% against the Euro December 13, 2005, and the Euro fund has increased about 12.5% which reflected by this currency’s pattern. Most investors would consider that a respectable return, especially with an asset class that historically has had little correlation to domestic equity returns.

Smoke and Mirrors

Rydex’s CurrencyShares carry a .40% expense ratio for the privilege to invest in the particular currency. The expenses are paid out of the interest (if the interest rate exceeds the .40% expense ratio) that is received on the account; therefore, the investor is oblivious to the actual “cost” of ownership.

For instance, an investor feels that the Euro would be a good investment in the long run, so he/she takes a long position in CurrencyShares Euro Trust (FXE). Suppose that this investor wanted to buy $100,000 worth of Euro; today he would effectively be going long €74,900. The Euro is currently yielding 3.54%, which comprises the fund, and the .40% expense ratio would be deducted from the interest payments on the Euro currency holdings. While the investor is receiving about $3,540 in interest per year from the position, he is paying about $400 in expenses per year because of that .40%, leaving him with an interest gain of about $3,140 per year. According to the fund fact sheet, “Because CurrencyShares will be traded as securities, transaction costs will be substantially reduced compared to currency spot market transactions.” This statement, however, is not true in all cases and is very misleading to investors who feel that currency would be a good holding in their portfolios.

The “Low-Cost” Alternative

Over the past few years, the emerging market of Foreign Exchange (FOREX) has been gaining a lot of recognition and respect, and many brokers today focus purely on trading in this new and up-and-coming global market, helping investors to easily reap the many advantages. The FOREX market is the most liquid market in the world, with about $2.7 trillion traded per day, and it is available to trade 24 hours a day.

If an individual investor were to take that same $100,000 long Euro position directly through a FOREX broker, he would be able to reduce expenses dramatically by about 98%. He would still be going long €74,900, but this time without the .40% expense ratio. The only cost to initiating the position is the spread cost, which on the major currencies is usually only one to five pips. In this case, the spread cost to initiate this position would be around $9.00, which would roughly be the same as the broker commission to buy into the currency ETF. After this initial cost, there are no further expenses for the investor to pay. The spread costs will differ among FOREX brokers; therefore, a trader should shop around for the best spread cost and interest rates.

If the investor were to take the position through the FOREX broker, he/she would be able to yield about 3.40% per year, which would give the investor roughly $260 more in interest than the CurrencyShares Euro Trust. The lower interest rate received of 3.40% is because on the currency transactions there is spread on the interest rate. The broker keeps this, which is similar to what banks do when they pay out interest on deposits and lend out money at a higher rate.

Another benefit that comes with investing directly through a FOREX broker is the ability to leverage the equity in your account. Each FOREX broker is different in the amount of leverage that an investor can use, but typically it is around 50 times the account equity. FOREX brokers offer this type of leverage because when trading currencies, an investor is effectively buying (investing) one currency and selling (borrowing) another simultaneously. In the above examples of going long the Euro, the investor is actually going short the US dollar. An investor should have a good understanding of the market before engaging in leveraged currency transactions; every investment should be an educated investment.

So, What’s Your Point?

The Rydex CurrencyShares ETFs have extraordinarily high expenses considering the type of product they are offering and the relatively low barrier to entry into trading the actual product directly in the FOREX market. They are able to rebalance their currency holdings with little transaction expenses into an always very liquid market, which is often difficult for equity ETFs to do.

ETFs can be incredibly helpful. When comparing the total cost it would take for an individual investor to buy into the individual stocks that comprise the S&P 500, and the total cost to buy into a currency, it is easy to understand why there are ETFs for the former. But the latter, as shown above, has very little cost to initiate; a currency trade is fairly easy and inexpensive, yet the Rydex CurrencyShares ETFs charge more than four times the expense ratio than that of ETFs that trade the S&P 500. It’s ludicrous!

The amazing fact about the CurrencyShares ETFs Family is that they now boast $1.7 billion in Total Net Assets in their eight funds. I guess it goes to show that in a booming market, people will buy anything, just as long as they hear the right pitch.

Technorati Tags: Rydex, currency, CurrencyShares, ETFs, FOREX

You can view the real-time holdings and performance of this strategy at http://stockalicious.com/stock_journal/553

Investment Strategy:

The portfolio strategy was developed around the use of the new leveraged ETFs (Exchange Traded Funds) that seek to double the daily performance of a particular index. The idea was first presented in the blog post entitled “Utilizing Leveraged ETFs to Simulate the Performance of the S&P with Less Risk“. The strategy is to create a diversified portfolio, which will lower the risk of the portfolio as a whole, all while maintaining the profitability of investing in an index. The goal of this portfolio is to allow a long-term investor to create a basket of securities that do not limit the upside potential of being invested in equities, while creating a cushion if the equity markets become negative. The main focus of the portfolio is for capital preservation, which is accomplished by investing in two asset classes that typically move inversely depending on the market conditions. Ideally, the portfolio would be rebalanced yearly to preserve the initial allocations. The yearly rebalancing will take profits on a security that has increased in value and add to positions in a security that have decreased in value over the year.

The initial allocations of the portfolio are as such:

The allocations by asset class are as follows:

Since the portfolio was started on June 21, 2006, and the investment strategy calls for a yearly rebalancing, I decided to rebalanced the portfolio on January 2, 2007 to the following allocations:

There were sells Proshares 2x Leveraged S&P 500 ETF and the iShares EAFE Value Index ETF. I added to all of the fixed income positions to bring them back into line with the suggested allocations.

Below are the current positions and their values as of April 20, 2007:

By clicking on the picture below you can view the entire transaction history.

Past Performance:

The performance, since June 21, 2006, has been positive, and it has beaten its benchmark of the S&P 500. The portfolio as of Thursday, April 19, 2007, has a return of 23.41% (including dividend reinvestments), while the S&P 500 has returned 17.45%. The portfolio outperformed the benchmark by 5.96%, all while diversifying the portfolio with fixed income and international equity allocations. While this past performance is only taking into account a short testing period, by following the investment strategy, the portfolio should continue to exceed the index benchmark.

Description of Portfolio Holdings:

SSO – Proshares Ultra S&P 500 ETF – This is the core holding in the portfolio; it gives an investor the ability to invest in a basket of 500 stocks and leverage those at 2 times via the use of options, swaps, and other derivatives utilized by the management company. The expense ratio on this ETF is .95%, which is a bit on the high end for an ETF, but when the investor takes into account the benefit of leverage, the expense ratio comes to about .425%, which is comparable to similar index funds. The competition portfolio had an initial ratio of $50,000 invested in this fund, which represents 50% of the initial capital, and a pseudo-position of $100,000 since the ETF is 2 times leveraged.

AGG – iShares Aggregate Bond Index ETF – The second largest holding the portfolio, this ETF is the core fixed income asset. It is also not a leveraged product, but it gives the investor the exposure to the less volatile fixed income market. The idea in utilizing this security is to hold an asset that has a low correlated, inverse relationship to the equity markets. The ETF is diversified among 143 securities, currently yields 4.63%, and has an expense ratio of .20%. The initial allocation to this ETF was 25% of the portfolio, or $25,000.

EFV – iShares EAFE Value Index ETF – This is the other equity holding in the portfolio. This ETF gives the investor a one to one exposure to the strong international markets. This ETF is also a play against the continued depreciation of the US Dollar against all the major world currencies. It is diversified among 531 companies located in the mature European, Australasia (Australia and Asia), and the Far East markets. The expense ratio for this ETF is .40%. The portfolio’s initial allocation to the EAFE Value Index ETF was $15,000 or 15% of the portfolio.

TIP – iShares Treasury Inflation Protected Securities ETF – The key idea behind using this ETF is to protect against inflation, which is a potential problem should energy prices continue to rise and the US Dollar continues to fall causing foreigners begin to stop financing the US Government debt. The fund currently yields 4.35% and has an expense ratio of .20%. The fund is only invested in US Government bonds making this fund fairly risk free. The initial allocation to this ETF was $5,000, or 5%.

LQD – iShares iBoxx Investment Grade Corporate Bond ETF – The utilization of this ETF is to diversify the bond holdings to the higher yielding corporate bonds markets. The fund only invests in Investment Grade bonds; therefore, the risk is relatively low. This fund would have a higher correlation to the equity markets than the Aggregate Bond Index, which holds more government securities. The fund is diversified among 100 different securities, currently yields 5.65% and has an expense ratio of .15%. The initial allocation to this ETF was 5%, or $5,000.

Long-Term Leveraged ETF Performance:

One of the risks in investing in Leveraged ETF products is that they are rebalancing the composition daily because they are used to double the daily performance of the market. Therefore, in the extreme example, if the market fell 10% today and rose 10% tomorrow, on an actual index the loss would be 1%, while a leveraged ETF would have lost 20% today and gained 20% tomorrow, giving a total loss of 4%. In that instance, the compounding effect could have a substantial negative effect on the portfolio performance.

However, before choosing this strategy, I ran a test going back to 1998 when the first 2 times leveraged fund was introduced as a mutual fund. This fund was the ProFunds UltraOTC Mutual Fund (UOPIX), which doubled the daily performance of the NASDAQ 100. A simulation ran with an initial $100,000 investment, half committed to the Ultra Fund and the other $50,000 committed to the Vanguard Total Bond Market Fund (VBMFX). The portfolio was rebalanced on a yearly basis, by keeping the 50/50 allocation. While an initial investment in the NASDAQ 100 back in 1998 at the start of this simulation would be worth, total, about $150,000, or a 50% return, the test portfolio that was rebalanced yearly between the UOPIX NASDAQ Fund and VBMFX is worth $283,092 today, yielding a 183% return. The reason for the substantial outperformance was that when the NASDAQ continued to climb during the technology bubble, people were taking profits out of the leveraged position (selling shares) and placing those gains into the bond fund. Then during the tech bubble crash and subsequent recession, profits were taken from the bond fund, which increased tremendously during that time, and reinvested into the 2x NASDAQ 100 fund to maintain the 50-50 allocation. When the NASDAQ finally began to recover, we were able to receive those benefits from the constant rebalancing. As one can see, the rebalancing creates an effect that takes profits as the market climbs while adding to positions as the market falls. The fact that this portfolio withstood a huge fall in the NASDAQ following the bubble years shows the true long-term stability of this approach.

I could not obtain a graph going back to 1998, but the graph below goes back to April 6, 2002. As shown, the Leveraged Portfolio has performed almost in line with the Nasdaq 100. The strategy will underperform the market during bullish times, as seen currently in the market, but in a downturn, the fixed income aspect will play a bigger role in capital preservation.

Conclusion:

This portfolio strategy is very low maintenance and does not require individual security analysis. To the typical investor, the individual company analysis is very stressful and can take a lot of time to develop. Thus, this strategy allows the investor to create a portfolio that systematically promotes smart money management techniques and takes out the time commitments that come with building a truly successful portfolio. The strategy behind this portfolio allows the investor to set it and forget it for a year. Though I would not see the NASDAQ 100 as a good long-term index, the investment portfolio developed for this competition follows the S&P 500, and can give a long-term investor the ability to take out the stress of investing. The original goal for this competition tasked us to develop a strategy that would allow someone to save for retirement and for his/her children’s college tuition. Therefore, I would say that a somewhat conservative approach that allows an investor to use hedge fund tactics meets those criteria. For that type of investor, something with diversification is ideal. I fully believe that this portfolio meets the goals of this investor or any investor who seeks good long-term returns with minimal thought, effort, and risk.

You can view real-time holdings and performance of this strategy at: http://stockalicious.com/stock_journal/656 

As mentioned in a previous post about the performance of the Leveraged ETF portfolio, I am currently testing a fully diversified portfolio that should perform in any type of market. While the performance may be mute and more of an average, the risk should be a lot less than a pure equity portfolio. The performance is also magnified by the leverage aspect of the portfolio which will increase the total returns, but
may increase the portfolio’s risk.

I put together a portfolio of different ETFs and Mutual Funds and the composition is as follows:

(Name – Ticker Symbol – Allocation)
Direxion S&P 500 Bull 2.5x – DXSLX – 33.74%
ProFunds Ultra International – UNPIX – 12.27%
ProFunds Ultra Emerging Markets – UUPIX – 4.29%
ProShares Ultra Real Estate – URE – 4.91%
PowerShares DB Commodity Index Tracking – DBC – 6.13%
Direxion 10 Year Note Bull 2.5x – DXKLX – 10.74%
ProFunds U.S. Government Plus – GVPIX – 6.13%
Vanguard Convertible Securities Funds – VCVSX – 6.13%
PowerShares Listed Private Equity Portfolio – PSP – 6.13%
iShares Treasury Inflation Protection Index Fund – TIP – 6.13%
Flaherty & Crumrine Preferred Income Opportunities – PFO – 3.37%

The portfolio allocations roughly match that of the Pennsylvania State Employees Retirement System, whose current allocations can be viewed here. This structure manages risk, but also looks to generate outsize returns in any market condition.

The performance of this test portfolio since inception on March 8, 2007 has been -1.28%, while the S&P 500 over that same period of time has declined by 3.65%. For an outperformance of 2.37% over the S&P 500. The chart below shows the since inception return with the blue line representing the suggested portfolio in this post, while the yellow line is the return of the S&P 500.

Click on the chart to see a larger version of it. As you can see from the chart above, the returns of this portfolio have been less volatile against the broad stock market which was hit the hardest on February 27, 2007 when the stock market declined over 4%. Further testing will need to be completed in regards to the stability of the returns and the perceived outperformance. Please look for updates in regards to the performance, I will be posting return updates monthly.

This analysis does not take into account commissions, fees, purchase minimums and taxes. If you should have any questions please feel free to comment on the blog and I would be happy to provide you an answer.

It has been one month since I posted the Ultra-Leveraged, Speculative ETF Strategy on the site. I have actively been testing this strategy since I posted the idea. In the example, I had mentioned how we looked to take a bear market approach to the S&P 500 since it was approaching the 1999-2000 peak and the market has not corrected more than 4% in over three years. Here is the update as of March 7, 2007:

On February 8, 2007 the following purchases were made in the $145,000 portfolio:

Long SDS – Proshares Ultrashort S&P 500 ETF – Trading at $56.20
We take a $145,000 position in that ETF by purchasing 2,580 shares for a total cost of $144,996

Short SSO – Proshares Ultralong S&P 500 ETF – Trading at $89.47
We take a $145,000 short position in this ETF by purchasing 1,620 shares for a total cost of $144,941.40

Let us fast forward to the present day of March 7, 2007 and take a look at the portfolio’s performance.

Long 2,580 shares of SDS – Proshares Ultrashort S&P 500 ETF currently trading at $61.04
This position is now worth $157,483.20, for a profit of $12,487.20, which represents a 8.61% gain

Short 1,620 shares of SSO – Proshares Ultralong S&P 500 ETF currently trading at $82.29
Our short position is now worth $133,309.80 (Since this was a short sale this is what we will buy back the position for, so our profit is ~$144,941.40 – $133,309.80), for a profit of $11,631.60, which represents a 8.03% gain

Our entire portfolio is now worth $169,118.80 representing a total profit of $24,118.80 or 16.63% in just one month (+199.56% Annualized Return). These results may overstate the expected return from this strategy due to this past month being a bit abnormal due to the huge drop towards the end of February and into the beginning of March (see February 27: A Much Needed Breather).

This past month has shown the real potential for using this Ultra-Leveraged, Speculative ETF Strategy, but it also demonstrates the real risk in this strategy because if your prediction was wrong, you could easily be in the hole 16.63% instead of up that amount. For a more conservative approach to utilizing the leveraged ETFs please view Utilizing Leveraged ETFs to Simulate the Performance of the S&P with Less Risk.

This strategy does not take into account taxes or commissions. If you have any questions, please feel free to leave a comment below and I will be sure to address it.

When I first introduced this strategy, I mentioned how it could have been used following the recession from 2000 – 2002, that strategy can be viewed here. A new interest has been shown in this strategy following the 4% drop of the S&P that occurred in the month of February because of the events that took place on February 27, 2007. Investors are finally realizing that they had taken on too much risk and now they are rebalacing their portfolios. Another new issue is how correlated the global markets are now, most investors thought that by investing in International companies that they were protected from negative news domestically, however, last Tuesday has proved otherwise.

Over the past month the S&P 500 has declined 4%, while aggregate bonds has increase around 1.25%. If someone where to enter into the leveraged ETF strategy on February 1, this is what their portfolio would have looked like today, March 3, 2007. I will also provide a comparision of what your portfolio would have looked like if you were only invested in the S&P 500 ETF.

$100,000 Leveraged ETF Portfolio (February 1):

SSO – Ultra S&P 500 Proshares – 563 shares bought at $88.73 ($49,954.99)
AGG – iShares Lehman Aggregate Bond – 501 shares bought at $99.76 ($49,979.76)
Total invested: $99,934.75

Leveraged ETF Portfolio (March 2):

SSO – Ultra S&P 500 Proshares – 563 shares @ $81.50 ($45,884.5)
AGG – iShares Lehman Aggregate Bond – 501 shares @ $100.65 ($50,425.65)
AGG Dividend on 501 shares @ $.393 ($196.90) – February 1
AGG Dividend on 501 shares @ $.394 ($197.40) – March 1
Cash: $65.25
Total Portfolio Value on March 2: $96,769.69 (-3.23%)

If an investor was strictly invested in the S&P 500 ETF, their portfolio would look like this on February 1:
SPY – SPDR – 693 shares at $144.15 ($99,895.95)

This is how it would look on March 2:
SPY – SPDR – 693 shares at $138.67 ($96,098.31)
Cash – $104.05
Total Portfolio: $96,202.36 (-3.80%)

While that difference does not seem to make that huge of a difference in the long run, should the US economy experience a period of slow growth and perhaps dip into a recession, an allocation to bonds while being invested in stocks, as shown in my previous post about utilizing ETFs to lower your risk. Although in the previous example there was an allocation to a money market fund, in this example, I chose bonds to show how an allocation to bonds would be an ideal situation for the investor.

I will be doing a further analysis on utilizing new ETFs, such as commodities and real estate to further lower the risk in your portfolio and generating market beating returns.

This analysis did not take into account taxes or commissions.

For those of you who are risk takers, speculators, or just looking to make a quick buck, this next strategy may be for you. Going back to a previous strategy where we were utilizing leveraged ETFs to achieve greater diversification and less risk, we are now going to use those leveraged ETFs to massively leverage our portfolio.

As of February 8, 2007, the S&P 500 is currently trading at 1444 and its index tracking stock the SPY is currently trading at 144.60. The market for the month of February has been on a tear and my belief is that we are about to experience a short-term pull back. There are two types of ETFs, there are Ultra-short, which go up 2% for every 1% loss in the S&P and there are Ultra-Long, which go up 2% for every 1% gain in the S&P.

To idea of this strategy is if we are bearish on the market, we will buy the Ultra-short and sell the Ultra-long, giving us a 4x leveraged position without buying on margin. The opposite should be done for a bullish market sentiment. For this example, I will use the Bearish strategy and explain the possible outcomes.

We will go long the Ultra-Short S&P ETF
We will go short the Ultra-Long S&P ETF
I will be going long $145,000 of the Ultra-Short ETF
I will be going short $145,000 of the Ultra-Long ETF

We are now trading at 4x the market movements, so for every 1% drop in the S&P our ETF holdings will increase 4% and vice versa,

Here are some potential outcomes with account starting value at $145,000:

The S&P 500 drops 5% in a month:
ETF holdings will be worth: $174,000
Total Account Value: $174,000 for a total profit of $29,000 or a return of 20.00%
For a month of holding this position we have an annualized return of 240%

If the S&P 500 goes against us and rises 5% this is how the portfolio will look:

ETF holdings will be worth: $116,000
Total Account Value: $116,000 for a total loss of $29,000 or a loss of 20.00%

This strategy while very risky, can magnify returns and could be utilized by small individual investors that want to trade at the day trade leverage of 4x, without meeting the requirements and being exposed to margin interest, because of the canceling out long and short position.

An interesting approach may be to identify two standard deviations from the price at the beginning of the month and place a buy at the lower end of the range and a short at the top of the range, this should encompass 95% of the total possible returns of the month. If a trader takes into account statistics in their trading, a strategy that leverages 4x can magnify the returns. Even if the opportunity to enter this trade presented itself just once a year, it is still can be a market beating strategy. If the market goes to three standard deviations then you can encompass 99.7% of the total market movements.

The leveraged ETFs while stating that they perform at 2x the daily movements may at times underperform or overperform that benchmark due to the value of the derivatives used to create the positions in the ETF.

Similar results can be acheived through options which your risk would be limited to the premium you paid for the call option. However, this initially puts you at a loss and creates a higher breakeven price than if you had just use the above strategy. Most likely if the market was approaching two or three standard deviations from the average then it would be possible to get contrarian options for relatively cheap.

Taxes and commissions were not taken into account during this example.

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!