A recent issue of Grant's Interest Rate Observer motivated me to look at the effects of volatility on levered funds. I find the combination interesting in a market growing accustomed to a lack of volatility.
Paraphrased from a recent investor letter: Since the VIX (Volatility Index) was introduced in 1990, the index has closed below 10 on only 16 days. Remarkably 7 of those days occurred since May 1, 2017. From 1990 to 2016 the average closing level of the VIX has been around 20; for 2017 year-to-date the average closing level has been around 12. [1]
The concern relates to investments structured in response to the current investing climate; leveraged investments benefit from low volatility (as the attached template demonstrates). In contrast, a spike in volatility can go so far as to reverse these returns.
Per Jim Grant: "Say that you own $100 of a thrice-leveraged ETF. On day one, the underlying index moves up by 5%; it's worth $115. Next day, the index falls by 5%; oops, your fund is now worth $97.75. Repeat across 10 days - alternating up 5% and down 5% - and you finish with $89.24, down 10.8%. Over the same course of choppy trading days, an unlevered fund would have lost only 1.2%. 'At higher ranges of volatility,' warns the summary pospectus for the Direxion Daily S&P Biotech Bull 3X Shares, 'there is a chance of a near complete loss of value in the Fund, even if the Index's return is flat." [2]
As the template attached shows, the appeal of these funds comes from the outsized returns generated by upward trends and low volatility. Changing the input in cell E10 from 1% to 5% demonstrates how returns are inflated.
The template has three examples:
- Comparison of a levered and unlevered fund with low volatility and upward movement.
- Comparison of a levered and unlevered fund mirroring the price movements described by Jim Grant above.
- The last example is similar to the second example, but demonstrates the outcome with actual leverage recalculated each trading day.
Footnotes:
[1] Paraphrased from an investor letter dated July 13, 2017
[2] Grant's Interest Rate Observer, May 19, 2017
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