Friday, February 23, 2018

New-to-Market: PPLC

Friday, February 23, 2018 - New-to-Market: This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors. While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts!

When we first began our “New-to-Market” series, it was with the intention of showcasing recently introduced funds from smaller sponsors that might have otherwise struggled to stand out in a crowded field. With 275 new funds coming to market in 2017 and 60 so far in 2018, the field has become very crowded indeed. Even new funds from the major players like Blackrock, State Street or Vanguard, can easily be overlooked. This why for our latest edition, we have decided to cast our eye backwards to a series of funds first launched in 2015 that have proven to be strong performers even without the complicated and tortured strategies that predominate today’s market. Let's take a deeper dive into the recently relaunched and expanded Portfolio+ series of “lightly levered’ funds where we attempt to answer the question of whether it’s time to start taking levered funds seriously.

Now might seem an odd time to be talking about levered funds; we’re just weeks removed from the first substantial correction in years which has even the most diehard bulls feeling a little skittish, but the truth is that Direxion, a leader in providing levered funds and the parent of Portfolio+, has had some proving to do about the practical application of its “lightly levered” series. Not that the concept of levered funds is anything new to ETP investors; the first levered fund was introduced way back in 2006 after three years of review by the SEC and today our ETFG Models now track more than 200 levered funds with over $43 billion in assets. While that might sound impressive, it also amounts to less than 2% of the total assets held in ETPs. Their failure to gain market share during one of the strongest bull-markets of all time stems from the fact that while the basic concept of a levered fund is immediately understandable, even the most sophisticated investors often have difficulty with the practical application.

Enter Portfolio+ with its suite of six “lightly levered” funds that offer 1.25x leverage to a wide range of the most common investment benchmarks including emerging markets, developed international ex. U.S and the Barclays U.S. Agg with two funds that can offer a three-year track record, the Portfolio+ S&P 500 ETF (PPLC) and the Portfolio+ S&P Small Cap ETF (PPSC).

First launched in 2015 under the Direxion label, the series can likely trace its genesis from the realization that while levered funds have earned a mixed reputation, the core concept behind them is rooted in the same basic investment principles that underlie the entire market structure including the low-cost, passive investments products that are increasingly dominating investor portfolios. Anyone who survived a first-year investment class is familiar with the capital market line and the concept that the market portfolio is the most efficient one (maximum return for the amount of risk) and that the only real dilemma facing investors is to determine their optimum exposure to the market and adjust accordingly via beta.

While that may have been a radical idea in the 1950s, the entire investment industry since then has been rebuilt around the idea that any investor is unlikely to outperform the market over an extended period of time. So if you can’t beat them, join them by investing passively and only paying pennies on each invested dollar. Passive investment products now control more than one-third of all investment assets in the United States and while levered funds have gotten a bad reputation, some are still passive products, built around the same efficient market hypothesis offering exposure to the same benchmarks that dominate most investor portfolios, just at an “enhanced” level. In fact, when the series was first launched they were often referred to as “enhanced beta” products in order to tackle the biggest problem holding back levered funds, namely marketing.

Until now, levered funds were designed as a tool for traders, not long-term investors. Although many might have thought they were guaranteed twice the return of the index for as long as they hold it, thanks to levered funds following the standard ETP protocol of combining investment strategy and benchmark. Here, typically a “2x” or “levered” or “ultra”, followed by a well-known index like the S&P 500. Instead, thanks to the process by which the levered fund must rebalance itself to adjust its index exposure to maintain a constant leverage ratio between the fund and the benchmark results in path dependency, or that an investor’s return is dependent on the path of the benchmark after they bought it. Someone who, for two consecutive weeks, bought a 2x S&P 500 fund on Monday and sold it on Friday could have two very different weekly returns even if the S&P 500 was flat overall depending on the direction the market traded each day and its overall volatility. This is why all levered fund literature comes with warning labels on holding periods and making it no surprise that investors looking to juice their portfolio returns preferred high beta and momentum funds to levered products.

Portfolio+ intends to transform levered funds from being strictly a trader’s tool to a core holding by using only a modest amount of leverage while retaining the underlying exposure to the most common investment benchmarks. Like their more aggressive kin, the 1.25x funds still feature a daily rebalancing to maintain the proper leverage ratio meaning they still have some degree of path dependency but the lower leverage ratio should reduce the impact on portfolio returns, making the fund potentially more suitable for investors with a timeframe longer than one day. And if you find the notion of a levered fund as a core holding somewhat laughable, ask yourself if some Financial Advisors might not already be doing something similar with smart beta funds.

First introduced in 2013, smart beta funds have quickly have grown to be considered an indispensable tool for Financial Advisors. Investment professionals often pair a smart beta fund with a passive benchmark replication in an effort to enhance returns, either by raising the overall portfolio beta or by seeking a different beta source all-together.  It seems that with over 1,000 smart beta funds and $1 trillion in assets, investors are clearly open to the idea of pairing funds to build a better beta. The question is whether they’re buying smart beta when they really want enhanced beta offering more of what they already own.

Two of the more common arguments in favor of enhanced beta begin with the fact that even while Advisors are picking passive strategic beta funds, they are still making an “active” decision to attempt to outperform the market.  This requires regular monitoring and often replacement as investment styles, or factors, come in-and-out of favor not unlike (or perhaps because of) traditional sector rotation and thus defeats the purpose of passive investing. Secondly, even with path dependency, levered funds apply a relatively straightforward system to a well-established benchmark.  A 2x levered S&P 500 fund should, on a day-to-day basis, produce twice the return of the S&P 500, whereas even with a “high beta” fund, the potential returns are entirely dependent on the underlying holdings.

Case in point is the largest fund in the Portfolio+ lineup, the Portfolio+ S&P 500 Fund (PPLC), which in the past was often compared to the PowerShares S&P 500 High Beta Portfolio (SPHB.) Both funds are linked to the S&P 500 and like PPLC, the PowerShares fund follows a straightforward strategy that every quarter selects the one hundred S&P 500 components with the highest beta over the past year and weights them by beta although without an explicit beta target for the overall portfolio like PPLC. What that can get you is often highly concentrated exposure to one sector well beyond its weighting in the S&P 500 resulting in an unpredictable return relative to a more straightforward levered fund. Despite having a beta of 1.37 over the last three years, SPHB often has drastically different performance from the S&P 500 first underperforming the S&P by 1,400 bps in 2015 then outperformed it by 1,400 bps in 2016.  In fact, SPHB has substantially underperformed the S&P 500 from inception through the end of 2017 to the tune of over 300 bps on an annualized basis according to literature on the PowerShares website and with substantially higher volatility than the market, offering a risk/return tradeoff substantially different than a levered fund.

By comparison, PPLC’s return has been more predictable with the fund up 14% in 2016 and 27% in 2017 compared to 12% and 21.8% respectively for the S&P 500 which astute readers will note is very close to the 1.25x return goal of the fund as even lightly levered funds still suffer from beta slippage although like all levered funds, the extended period of low volatility helped reduce the magnitude of the daily rebalances and thus lowers the beta drift. PPLC even managed to hold its own during the recent correction as the S&P 500 lost 8.82% from January 29th to the close on February 9th after which the market recovered over 3% from the 10th through the 21st leaving it down 5.9% overall.

Faithful to their natures, both PPLC and SPHB were down over 10% as the market began to break but followed very different paths as it began a cautious recovery.  Both have outperformed the S&P 500 since it bottomed on the February 9th with SPHB delivering a solid 4.4% return from February 10th to the 21st while PPLC managed a more substantial 5.1% which has left it almost neck-to-neck with the unlevered market return.  Although to point out again, this is a relatively short time frame and the drop-in market volatility has helped lower the portfolio’s path dependency and beta drift.  However, it still seems an impressive turn for a relatively new fund strategy that only charges .34% for its enhanced exposure.   

Ultimately, some might think that this long period of a steadily climbing market and low volatility might not be a fair test of enhanced beta, but the Portfolio+ suite of lightly levered funds have seemingly delivered on their promise of offering a more predictable tool for asset allocation to stay on top of the nuances of smart beta funds and portfolio construction. Levered funds ultimately might not be the most exhilarating development among ETP enthusiasts, but the rise of enhanced beta might be the next big thing for those in the front lines of portfolio management.

Thank you for reading ETF Global Perspectives!

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