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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