That was kind of the tone from Morningstar about the spate of single stock ETFs including that they are "Jack Bogle's worst nightmare" as well as the proclamation that no, you should not buy a single stock ETF. If you're new to this, these ETFs do track just one stock. For now they offer leveraged long exposure, inverse exposure which would allow for effectively going short without a margin account (like in an IRA) and another type of single stock ETF in the regulatory hopper would provide exposure to foreign stocks that are only traded over the counter, not traded on the NYSE or NASDAQ.
We taken several looks at the potential tracking error of these types of ETFs because the precise objective is to track the underlying on a daily basis. There is a reset everyday so that tomorrow it will again do what it is supposed to just for that day and then repeat everyday. The sequence of the resetting process can cause a tracking error. It doesn't have to cause a tracking error but it absolutely could cause a result that looks much different that holders would hope.
My contention has long been that the daily reset is nowhere near as problematic as the pundits would have you believe. Yes, going forward the results could be terrible but that threat has always existed but any time I've play around with any of them, they "work" more often than not. As one reader on yesterday's post pointed out, don't expect dividends from levered funds either.
I used Portfoliovisualizer to compare 100% SPY to 50% in 2x S&P 500/50% in BIL and 33.3% in 3x S&P 500/66.7% BIL.
The results show very close tracking between all three expect for 2020 when SPY outperformed due to what appears to be an adverse sequence of daily resets during the Pandemic Crash and immediate bounce back.
Here's more
The potential here is capital efficiency which we've been talking about all summer and that I tried to explore in yesterday's post. Using BIL as a proxy for a risk free asset, if everything tracked perfectly with SSO and/or SPXL then you'd get the full market effect with less of your capital at risk. If the stock market cut in half I don't think SSO and SPXL would literally go to zero but effectively so, yes. With SPXL and a 50% broad market decline, you'd only be out 33%, you would have had less capital exposed to risk assets. In the event of a decline like that you could rebalance into SPY, you still have all that BIL and you're in the same position with 2x SSO and wildly outperformed with SPXL.
This might be part of the return stacking discussion we've been having too. An allocation to a reasonably reliable negatively correlated at the expense of BIL would have the effect of leveraging down. I am confident in managed futures, certain volatility strategies and certain long/short funds going up when stocks go down, confident not certain, but in the face of a catastrophic decline for SSO or SPXL some strategy that benefits from market declines could help smooth out the ride of the overall portfolio. That idea is consistent with what we've been doing all summer trying to build replacement portfolios with alternatives that create the effect of doing what 60/40 used to do but without taking interest rate risk.
What we're talking about today is very similar but with less exposed to risk assets by virtue of the large allocation to risk free T-bill assets.
Yeah, you may never use any sort of leveraged product. I've used 2x inverse before but yeah, I might never use a leveraged long product but the concept of capital efficiency, whether it is what we've talked about above or barbelling volatility inside of a more conventional looking portfolio or something else. To naysayers of new things I would say to instead understand the use cases for things that are unfamiliar, what little bit can be taken from new (to you) strategies and products to enhance your investment process even if just incrementally.
As the single stock ETFs rollout, as opposed to running screaming from the room flailing my arms over my head, I want to keep close tabs on what lists, how they do and continue to work on whether I might ever use them. What stays out of the portfolio might be as important as what goes in, I believe in making informed decisions on both sides of that ledger.
4 comments:
I feel like maybe we need a new lexicon to use when discussing leveraged investments. I have not found PV to be of any help. 50% SSO and 50% BIL is really 150% of exposure, with 100% being S&P 500 and 50% being BIL. When we compare that to 100% SPY, we need to be reminded of the leverage. In this example, why did 100% SPY have a higher CAGR? Because BIL returned virtually nothing, and SSO did not deliver on its promise of 2x SPY returns. It appears that it delivered 1.68x in the 2012-2022 period. "Exposure" is a good concept to work with. Normally, one would expect a port with 150% exposure to return 150% of the unleveraged port, which is the foundation of capital efficiency. Is there a good way of measuring capital efficiency of a port?
This becomes even more complicated when one has a whole portfolio (as I am trying to assemble) of leveraged, multi-asset funds.
The tools available are way behind. I have created a spreadsheet that deals with it, but it is very manual and therefore prone to error. If anyone has ideas of how best to solve this problem, I'd love to hear them.
@Max,
So obviously this is all a process, we're sort of making sausage here. Much of the lag of the SSO portfolio is attributable to 2020. The rest of the time it was much closer. Was it close enough to be a proxy? That's up to the end user, no wrong answer.
The risk of it not "working?" That is certainly a drawback but any portfolio any of us has ever constructed had drawbacks as would any portfolio, theoretical or actual, we implement in the future.
Glad the posts are resonating!
Hi Roger,
For my own clarification, you have managed my portfolio with strategic and tactical positions. I would expect you to take the Fed at face value, to some degree, and use that as a guide for a shift to reduce or eliminate exposure to interest rate exposure. The presentations I’ve been reading on the blog are not using tactical changes, but are modeled on a permanent portfolio, if I am understanding the narrative correctly.
My question is would you not be using these as tactical tools, not permanent positions, in an actual portfolio? I understand you want to stress test these products under many conditions , which makes alot of sense. If they are not performing when you don’t own them, is it a fair test for their utility under their intended conditions? (Kind like using snow tires in the summer time).
I’ve enjoyed the blog. Thanks for starting it back up.
@anon,
Sorry for the delayed reply, I don't get notifications of comments for some reason.
A lot of people would like a portfolio designed so well that changes never need to be made and it is fun to write about that. Some positions in the portfolio have been there for many years and ideally, would never need to be sold but if the day comes that they do need to be sold then yes, I would sell. That's broadly speaking.
The diversifiers in the portfolio are generally tactical yes but no way to know how long. We've been very underweight longer dated fixed income for many many years, how long will that continue? Not sure but 3-ish percent for 10 years makes no sense but 2.4% for 16 months is more reasonable, some of the other fixed income holdings also avoid interest risk, not that the are impervious to going down but we're staying away from duration.
We've had a couple of alts as fixed income substitutes for a long time like MERFX, it has the volatility profile of what I think people hope from their fixed income exposure but no interest rate risk. If we get some sort of washout cleansing in terms a drop in the S&P 500 then I'd take off some portion of the alts and replace that with more equity beta. Down 24% as a low for now wasn't much of a washout to do a lot IMO. We've made a couple of tweaks increasing/decreasing equity exposure incrementally over the last couple of months but nothing big because amount it's been down so far has been fairly run of the mill. Hope that makes sense!
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