Why 3x S&P 500 ETFs can be held long-term

Many articles argue that one shouldn’t hold leveraged ETFs long-term. Like many things, it depends on the situation. For certain leveraged ETFs that have high volatility, that is prudent advice, but for underlying asset classes with low volatility and long-term positive returns (such as the S&P 500), 2x and 3x versions can be held long-term.

  1. very low volatility. The S&P 500 has a realized volatility of around only 6-9%, which significantly minimizes volatility decay. According to my calculations [1], this results in a a decay of only around 1.5% per year for UPRO.
  2. but also importantly, dividends are automatically added to the NAV. For UPRO, this is a 6%/year boost. This also has tax implications because it means you aren’t taxed for dividends.
  3. for periods of low volatility and strong returns, 3x ETFs can outperform. This means that a portfolio that is 2/3 cash and 1/3 a 3x version (such as UPRO) will generate excess returns than a portfolio that is 100% invested in the unleveraged ETF (such as SPY).
  4. the losses are capped. If you put 1/3 of your portfolio in UPRO and the 2/3 in cash, even if the market were to fall to zero, you would still ONLY lose 1/3 of your capital. Hence, leveraged ETFs when used as a substitute for non-leveraged funds, sorta have a built-in put option.
  5. cheap leverage. Brokers charge outrageously high margin costs. If you have a $20k account and you want to use 2x margin to buy $40k of the S&P 500 ETF SPY, you will be paying a whopping 5% a year on that $20k ($1000). What a ripoff. Leveraged ETF providers, due to high creditworthiness of the their issuer, can borrow at close to the 3-month libor (around 1.5%/year), which means instead of paying $1000, you may only pay $300 or so (this is automatically deducted from the NAV of the leveraged ETF).

[1] http://greyenlightenment.com/estimating-the-decay-parameters-of-leveraged-inverse-etfs/