Gyroscopic Investing

Clive wrote: More likely leveraged funds will be holding a combination of 1x underlying and also be using derivatives. The time value (cost to borrow) for derivatives is typically similar to short term treasury yields. Those trading/borrowing costs would typically be absorbed from the fund value, not from the expense ratio, so the daily price of the fund reflect those costs having been absorbed. Although with higher expense ratio's, perhaps they proportion the costs to a bit of both expenses and from fund value.

If a Canadian holds 8.3% in each of US 3x stocks (BGU), 3x LTT (TMF), 3x Gold (UGLD) and 75% in Canadian short term treasury then they're exposed to

25% Stock
25% LTT
25% Gold
25% USD
75% CAD
75% lent (buy STT)
50% borrowed (via ETF's)

For the 75% CAD exposure, that risk is reduced by also holding 25% gold and 25% USD - to a 25% overall type amount.
75% lent and 50% borrowed is a net 25% lending overall amount.
There's also carry-trade positions in that (USD versus CAD interest rate differentials).

There's more asset classes to measure - and perhaps periodically rebalance (add-low/reduce-high).

Whilst that starts of relatively simple, after rebalancing - for instance to perhaps reduce USD, add to CAD so as to realign overall to 25% CAD exposure - you'll end up with a more mixed bag of USD and CAD holdings. So there will be more holdings/more rebalancing /more trading costs. That might however generate more rewards.

Clive wrote:

Gosso wrote:So we can expect that x2,3 ETF's will see a higher "slippage" when/if interest rates and therefore borrowing costs increase?

No - because the 'cash' you hold also rises/falls in reflection.

$100 total, you invest $50 in 2x, $50 in 'cash'.
2x ETF takes your $50, borrows another $50 at 'cash' rate and invests $100 in the 1x underlying stock.

If the cost of borrowing increases and the fund pays more for the $50 they borrow, you'll also receive more for the $50 in cash that you hold.

II. Buying Calls as part of an investment plan 

A popular use of options known as "the 90/10 strategy" involves placing 10% of your investment funds in long (purchased) calls and the other 90% in a money market instrument (in our examples we use T-bills) held until the option's expiration. This strategy provides both leverage (from the options) and limited risk (from the T-bills), allowing the investor to benefit from a favorable stock price move while limiting the downside risk to the call premium minus any interest earned on the T-bills. 

Assume XYZ is trading at $60 per share. To purchase 100 shares of XYZ would require an investment of $6,000, all of which would be exposed to the risk of a price decline. To employ the 90/10 strategy, you would buy a six-month XYZ 60 call. Assuming a premium of 6, the cost of the option would be $600. This purchase leaves you with $5,400 to invest in T-bills for six months. Assuming an interest rate of 10% and that the T-bill is held until maturity, the $5,400 would earn interest of $270 over the six month period. The interest earned would effectively reduce the cost of the option to $330 ($600 premium minus $270 interest). 

If the price of XYZ rises by more than $3.30 per share, your long call will realize the dollar appreciation at expiration of a long position in 100 shares of XYZ stock but with less capital invested in the option than would have been invested in the 100 shares of stock. As a result, you will realize a higher return on your capital with the option than with the stock.

If the stock price instead increases by less than $3.30 or falls, your loss will be limited to the price you paid for the option ($600) and this loss will be at least partially offset by the earned interest on your T-bill plus the premium you receive from closing out your position by selling the option, if you choose to do so.

Gosso wrote:

Clive wrote:

Gosso wrote:So we can expect that x2,3 ETF's will see a higher "slippage" when/if interest rates and therefore borrowing costs increase?

No - because the 'cash' you hold also rises/falls in reflection.

$100 total, you invest $50 in 2x, $50 in 'cash'.
2x ETF takes your $50, borrows another $50 at 'cash' rate and invests $100 in the 1x underlying stock.

If the cost of borrowing increases and the fund pays more for the $50 they borrow, you'll also receive more for the $50 in cash that you hold.

That makes sense.

I came across this in my reading on options, which sounds very similar to what you are suggesting, except with options:

II. Buying Calls as part of an investment plan 

A popular use of options known as "the 90/10 strategy" involves placing 10% of your investment funds in long (purchased) calls and the other 90% in a money market instrument (in our examples we use T-bills) held until the option's expiration. This strategy provides both leverage (from the options) and limited risk (from the T-bills), allowing the investor to benefit from a favorable stock price move while limiting the downside risk to the call premium minus any interest earned on the T-bills. 

Assume XYZ is trading at $60 per share. To purchase 100 shares of XYZ would require an investment of $6,000, all of which would be exposed to the risk of a price decline. To employ the 90/10 strategy, you would buy a six-month XYZ 60 call. Assuming a premium of 6, the cost of the option would be $600. This purchase leaves you with $5,400 to invest in T-bills for six months. Assuming an interest rate of 10% and that the T-bill is held until maturity, the $5,400 would earn interest of $270 over the six month period. The interest earned would effectively reduce the cost of the option to $330 ($600 premium minus $270 interest). 

If the price of XYZ rises by more than $3.30 per share, your long call will realize the dollar appreciation at expiration of a long position in 100 shares of XYZ stock but with less capital invested in the option than would have been invested in the 100 shares of stock. As a result, you will realize a higher return on your capital with the option than with the stock.

If the stock price instead increases by less than $3.30 or falls, your loss will be limited to the price you paid for the option ($600) and this loss will be at least partially offset by the earned interest on your T-bill plus the premium you receive from closing out your position by selling the option, if you choose to do so.

Source: https://swww.scotiaitrade.com/html/cust ... tml#bcalls

Although I'm thinking you have more creative methods for utilizing the cash. 

Can you think of any potential problems with using options instead of leveraged ETF's.  Obviously options use much more leverage and can easily become worthless, but this can be compensated by leveraging only ~10% of the portfolio, rather than 50% as for the x2 ETF's.

Side Bar: Apparently there are no options or leveraged ETF's for Long Term Canadian Bonds.  If I ever do this, I'll have to use options on TLT/EDV or leveraged US ETF's.

clacy wrote: It seems that a Canadian investor could easily compensate for the currency risk with a small amount of money in FX or options on the US or Canadian dollar if you employed this strategy (investing in US based leveraged trading vehicles).

Gosso wrote: I had a tough time wrapping my brain around how the 2x DAILY movement on the leveraged ETF's worked, so I used the random number generator to create a pseudo-leveraged index.  I had previously thought that if the index dropped 50% over a period of time then the x2 ETF would be zero, but this shows that assumption was incorrect.

Tortoise wrote: [EDIT: The approximation above applies mainly to Gosso's top two plots, where the price movements all tend to be in the same direction. In the bottom two plots, the up-and-down movements create volatility drag, which invalidates the approximation.]

Clive wrote: After each decline in the 1x, a 2x holds less leverage the next day. After each rise in the 1x, the 2x holds more leverage the next day. That puts a brake on declines and amplifies upsides, that your charts show.

In the top left chart, after the 1x had declined around -50%, the 2x was down around -75% (approximating by eye). In the top right chart, after the 1x had risen +50%, the 2x was up around 125%.

Holding half in the 2x as a synthetic 1x might see (respectively) +62.5% versus +50% on the upsides and -37.5% versus -50% on the downsides. i.e. half in the 2x is potentially better than holding the 1x.

Clive wrote: Nice charts Gosso

After each decline in the 1x, a 2x holds less leverage the next day. After each rise in the 1x, the 2x holds more leverage the next day. That puts a brake on declines and amplifies upsides, that your charts show.

In the top left chart, after the 1x had declined around -50%, the 2x was down around -75% (approximating by eye). In the top right chart, after the 1x had risen +50%, the 2x was up around 125%.

Holding half in the 2x as a synthetic 1x might see (respectively) +62.5% versus +50% on the upsides and -37.5% versus -50% on the downsides. i.e. half in the 2x is potentially better than holding the 1x.