Why should an investor use Leveraged Funds? 1) Better Outcomes: Yale professors did a study on the use of leverage on retirement investing from 1871-2004 (1): “By employing leverage to gain more exposure to stocks when young, individuals can achieve better diversification across time. Using stock data going back to 1871, we show that buying stock on margin when young combined with more conservative investments when older stochastically dominates standard investment strategies—both traditional life-cycle investments and 100%-stock investments. The expected retirement wealth is 90% higher compared to life-cycle funds and 19% higher compared to 100% stock investments. The expected gain would allow workers to retire almost six years earlier or extend their standard of living during retirement by 27 years.” 2) High Return: Leveraged Fund ETFs have the highest performance of any ETF going back to their inceptions according to Morningstar (06’ for double leverage, 10’ for triple leverage (2), attached). Leveraged funds will not duplicate double or triple the market return over longer than one day periods, which is disclosed in the prospectus. But since 06’ QLD is approximately 3.47 times the return as the underlying index, QQQ, which is one of the next best funds over the period (2). This includes the financial crisis of 08’ and other drops. 3) Higher Risk Adjusted Return Including Costs: S&P 500 leveraged ETF (SSO) and bond funds that are rebalanced monthly, can reduce the downside compared to the S&P 500 total return (2% outperformance during the pandemic, .98 Beta over 10 years, 4). Also adds extra risk adjusted performance per year including fees: 1.2 Alpha over ten years, including 1%/year advisory fee, underlying fund fees and a small cash portion that is common in a managed account. It also allows us to take on more risk than the market, which some clients are comfortable with, and has a long history of creating better long-term outcomes by diversifying time risk, than traditional portfolios as shown by Yale’s study above. 4) Tax benefits: a) Lower dividends/capital gains on leverage funds. QLD has less than 1% of the return from dividends or capital gains since inception vs. the stock market as whole averaging around 20% since 2006 (5). b) More efficient giving to charity with concentrated returns in one investment. c) More efficient tax write-offs during a market decline, with concentrated losses d) Allow for more bonds in the account, which is helpful for withdraws with lower taxes generally for selling bond vs. stock investments, as bond return is primarily from dividends, vs. stocks. 5) Withdraws: With more bonds, more flexibility for withdraws without materially changing overall risk, particularly during market downturns when selling aggressive investments is not ideal. E.g. – buying and selling a home transition, or in a down market for a retiree. 6) Compared to Margin: a) Lower Cost: Leveraged Funds allow for investing more money than they have in their account at a very low cost compared to a margin account, with no margin calls. Interest rates have ranges anywhere from 3-7% on margin, and slightly lower for a pledged account. The leveraged ETFs are roughly 1%/year as the expense ratio for the money in the account. If we compare that to the near zero cost of an index ETF, the cost is roughly 1%/year for that double leveraged fund, and roughly .5%/year for the triple leveraged fund. E.g - $100k invested in TQQQ, has $300k invested in the QQQ index per day for $950/year (.95%/year on $100k), compared to the Expense ratio of .15% for the QQQ index ($150). This is $800/year more to have $200k more invested, or roughly .4%/year cost for the extra exposure ($800/$200k). b) Won’t owe more than invested: Leveraged ETFs will not have the client owing more money than they invested, like margin. c) Use of derivatives: Derivatives have withstood the financial crisis inside these funds (See QLD, SSO), and after Dodd Frank, we believe that the government is even better equipped to protect companies from going under during a financial crisis (7). However, there is the possibility that the companies issuing the derivatives become insolvent and the value of these funds drop precipitously. This type of situation we believe would result in the collapse of the stock market itself, and regardless of derivatives would produce extremely adverse investments for investors of equity or fixed income. 7) Funds with leverage aren’t necessarily Increasing overall Risk: Many mutual funds and ETFs use investments that amplify the underlying investment exposure through the use of futures or options contracts that are also used in leverage funds. That was part of the reason that the leveraged fund use was not more regulated by the SEC in 2020 (4). The use of amplified investments in some funds did not actually produce high risk. E.g.: Pimco’s use of these products in bond funds like PIMIX, which holds 247% long, 154% short, allowing for higher dividend, lower duration than the index, and 3.5%/year extra return since 07’. About 62% less risky than the stock market during the pandemic (13% drop vs 35%). Q. What are the downsides of Leveraged Fund Use? More than one day hold: There are disclosures that investors should not use leveraged funds for more than one day. These funds will not multiply two or three times return over time because of sequence of return, compounding of daily investments, higher fees than the index, and lower dividends. See above for pros and cons of each of those situations. E.g. – QLD has returned 26.08%/year (~37 times the investment) vs. QQQ’s 16.39%/year (~10.6 times the investment) since inception in 06’. This is a deviation of 6.7%/year (32.78% (two times 16.39%) – 26.08%). This ETF still has approximately 3.47 times the return of QQQ over the last 15 years, which includes the financial crisis, pandemic and all the other drops. So while the returns are not double for more than one day, the long-term returns can exceed double the return because of compound interest. Therefore, we refute the argument that these funds should not be held longer-term, so long as the investor is still matching their risk and objectives. Triple risk funds: History since 2009-2010, so do not have the financial crisis to measure a steeper decline. Though sequence of return has worked in favor of leveraged funds during market drops, as UPRO (Triple S&P 500 fund) had a 78.34% decline during the pandemic of 2020 (5), vs. SPY’s (S&P 500 ETF) 35.3% drop (6) (Including intraday price and dividends). Three times 35.3% is a 105.6% drop (Total loss), so a ~21.66% outperformance of total loss. IF the market drops by more than 34% in a single day, UPRO could go to zero, but with market breakers, and if used in combination with other funds may not produce different outcomes than a traditional S&P 500 portfolio. Triple leveraged funds move faster, and therefore generally require even higher level of monitoring and rebalancing. Q. Should these be used for more conservative investors? Yes. IF the client has a time frame beyond five years, including more aggressive investments makes sense. Historically, including some stock, even for a conservative investor reduces the downside and volatility by adding a diversifying investment. Stocks and bonds have not been negative in the same calendar for 70 years (could in 2022). Markowitz Nobel prize is about using diversification to reduce risk and increase long-term returns. Higher volatility, yet lower correlation can produce lower risk, and higher returns. JP Morgan’s analysis on the worst five-year periods since 1950 shows a 50/50 portfolio (Stock/Bond) has a better downside than either stocks or bonds on their own (9). Leverage funds specifically allow an investor to use less of their allocation to achieve the target equity allocation. Historically this has mimicked day to day performance of an account without leverage. It is important to rebalance a leveraged account because it is prone to get more aggressive or conservative than a traditional account over time. 1: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1149340 2: https://finance.yahoo.com/quote/UPRO/history?period1=1577836800&period2=1585008000&interval=1d&filter=history&frequency=1d&includeAdjustedClose=true 3: https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP106.pdf 4: https://www.sec.gov/news/public-statement/lee-derivatives-2020-10-28 5:https://finance.yahoo.com/quote/QLD/history?period1=1150848000&period2=1645488000&interval=capitalGain%7Cdiv%7Csplit&filter=div&frequency=1mo&includeAdjustedClose=true 6: https://finance.yahoo.com/quote/SPY/history?period1=1577836800&period2=1585008000&interval=1d&filter=history&frequency=1d&includeAdjustedClose=true 7: https://www.stlouisfed.org/on-the-economy/2017/february/dodd-frank-act-financial-system-safer 8: https://www.sec.gov/investor/pubs/leveragedetfs-alert.htm 9: Page ~63: https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/
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Anonymous Comment On Regulatory Notice 22-08
Why should an investor use Leveraged Funds? 1) Better Outcomes: Yale professors did a study on the use of leverage on retirement investing from 1871-2004 (1): “By employing leverage to gain more exposure to stocks when young, individuals can achieve better diversification across time. Using stock data going back to 1871, we show that buying stock on margin when young combined with more conservative investments when older stochastically dominates standard investment strategies—both traditional life-cycle investments and 100%-stock investments. The expected retirement wealth is 90% higher compared to life-cycle funds and 19% higher compared to 100% stock investments. The expected gain would allow workers to retire almost six years earlier or extend their standard of living during retirement by 27 years.” 2) High Return: Leveraged Fund ETFs have the highest performance of any ETF going back to their inceptions according to Morningstar (06’ for double leverage, 10’ for triple leverage (2), attached). Leveraged funds will not duplicate double or triple the market return over longer than one day periods, which is disclosed in the prospectus. But since 06’ QLD is approximately 3.47 times the return as the underlying index, QQQ, which is one of the next best funds over the period (2). This includes the financial crisis of 08’ and other drops. 3) Higher Risk Adjusted Return Including Costs: S&P 500 leveraged ETF (SSO) and bond funds that are rebalanced monthly, can reduce the downside compared to the S&P 500 total return (2% outperformance during the pandemic, .98 Beta over 10 years, 4). Also adds extra risk adjusted performance per year including fees: 1.2 Alpha over ten years, including 1%/year advisory fee, underlying fund fees and a small cash portion that is common in a managed account. It also allows us to take on more risk than the market, which some clients are comfortable with, and has a long history of creating better long-term outcomes by diversifying time risk, than traditional portfolios as shown by Yale’s study above. 4) Tax benefits: a) Lower dividends/capital gains on leverage funds. QLD has less than 1% of the return from dividends or capital gains since inception vs. the stock market as whole averaging around 20% since 2006 (5). b) More efficient giving to charity with concentrated returns in one investment. c) More efficient tax write-offs during a market decline, with concentrated losses d) Allow for more bonds in the account, which is helpful for withdraws with lower taxes generally for selling bond vs. stock investments, as bond return is primarily from dividends, vs. stocks. 5) Withdraws: With more bonds, more flexibility for withdraws without materially changing overall risk, particularly during market downturns when selling aggressive investments is not ideal. E.g. – buying and selling a home transition, or in a down market for a retiree. 6) Compared to Margin: a) Lower Cost: Leveraged Funds allow for investing more money than they have in their account at a very low cost compared to a margin account, with no margin calls. Interest rates have ranges anywhere from 3-7% on margin, and slightly lower for a pledged account. The leveraged ETFs are roughly 1%/year as the expense ratio for the money in the account. If we compare that to the near zero cost of an index ETF, the cost is roughly 1%/year for that double leveraged fund, and roughly .5%/year for the triple leveraged fund. E.g - $100k invested in TQQQ, has $300k invested in the QQQ index per day for $950/year (.95%/year on $100k), compared to the Expense ratio of .15% for the QQQ index ($150). This is $800/year more to have $200k more invested, or roughly .4%/year cost for the extra exposure ($800/$200k). b) Won’t owe more than invested: Leveraged ETFs will not have the client owing more money than they invested, like margin. c) Use of derivatives: Derivatives have withstood the financial crisis inside these funds (See QLD, SSO), and after Dodd Frank, we believe that the government is even better equipped to protect companies from going under during a financial crisis (7). However, there is the possibility that the companies issuing the derivatives become insolvent and the value of these funds drop precipitously. This type of situation we believe would result in the collapse of the stock market itself, and regardless of derivatives would produce extremely adverse investments for investors of equity or fixed income. 7) Funds with leverage aren’t necessarily Increasing overall Risk: Many mutual funds and ETFs use investments that amplify the underlying investment exposure through the use of futures or options contracts that are also used in leverage funds. That was part of the reason that the leveraged fund use was not more regulated by the SEC in 2020 (4). The use of amplified investments in some funds did not actually produce high risk. E.g.: Pimco’s use of these products in bond funds like PIMIX, which holds 247% long, 154% short, allowing for higher dividend, lower duration than the index, and 3.5%/year extra return since 07’. About 62% less risky than the stock market during the pandemic (13% drop vs 35%). Q. What are the downsides of Leveraged Fund Use? More than one day hold: There are disclosures that investors should not use leveraged funds for more than one day. These funds will not multiply two or three times return over time because of sequence of return, compounding of daily investments, higher fees than the index, and lower dividends. See above for pros and cons of each of those situations. E.g. – QLD has returned 26.08%/year (~37 times the investment) vs. QQQ’s 16.39%/year (~10.6 times the investment) since inception in 06’. This is a deviation of 6.7%/year (32.78% (two times 16.39%) – 26.08%). This ETF still has approximately 3.47 times the return of QQQ over the last 15 years, which includes the financial crisis, pandemic and all the other drops. So while the returns are not double for more than one day, the long-term returns can exceed double the return because of compound interest. Therefore, we refute the argument that these funds should not be held longer-term, so long as the investor is still matching their risk and objectives. Triple risk funds: History since 2009-2010, so do not have the financial crisis to measure a steeper decline. Though sequence of return has worked in favor of leveraged funds during market drops, as UPRO (Triple S&P 500 fund) had a 78.34% decline during the pandemic of 2020 (5), vs. SPY’s (S&P 500 ETF) 35.3% drop (6) (Including intraday price and dividends). Three times 35.3% is a 105.6% drop (Total loss), so a ~21.66% outperformance of total loss. IF the market drops by more than 34% in a single day, UPRO could go to zero, but with market breakers, and if used in combination with other funds may not produce different outcomes than a traditional S&P 500 portfolio. Triple leveraged funds move faster, and therefore generally require even higher level of monitoring and rebalancing. Q. Should these be used for more conservative investors? Yes. IF the client has a time frame beyond five years, including more aggressive investments makes sense. Historically, including some stock, even for a conservative investor reduces the downside and volatility by adding a diversifying investment. Stocks and bonds have not been negative in the same calendar for 70 years (could in 2022). Markowitz Nobel prize is about using diversification to reduce risk and increase long-term returns. Higher volatility, yet lower correlation can produce lower risk, and higher returns. JP Morgan’s analysis on the worst five-year periods since 1950 shows a 50/50 portfolio (Stock/Bond) has a better downside than either stocks or bonds on their own (9). Leverage funds specifically allow an investor to use less of their allocation to achieve the target equity allocation. Historically this has mimicked day to day performance of an account without leverage. It is important to rebalance a leveraged account because it is prone to get more aggressive or conservative than a traditional account over time. 1: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1149340 2: https://finance.yahoo.com/quote/UPRO/history?period1=1577836800&period2=1585008000&interval=1d&filter=history&frequency=1d&includeAdjustedClose=true 3: https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP106.pdf 4: https://www.sec.gov/news/public-statement/lee-derivatives-2020-10-28 5:https://finance.yahoo.com/quote/QLD/history?period1=1150848000&period2=1645488000&interval=capitalGain%7Cdiv%7Csplit&filter=div&frequency=1mo&includeAdjustedClose=true 6: https://finance.yahoo.com/quote/SPY/history?period1=1577836800&period2=1585008000&interval=1d&filter=history&frequency=1d&includeAdjustedClose=true 7: https://www.stlouisfed.org/on-the-economy/2017/february/dodd-frank-act-financial-system-safer 8: https://www.sec.gov/investor/pubs/leveragedetfs-alert.htm 9: Page ~63: https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/