Portfolio Strategy

North America Market Commentary 12 April 2010

Phil Mackintosh
+ 1 212 325 5263
Victor Lin
+ 1 617 556 5658
Longer Term Plays on Leveraged ETFs
Key points
¾ The past few years have shown in practice
what we knew in theory about leveraged
ETFs – that while they deliver on their beta
on a daily basis, longer-term performance
can differ due to the effects of momentum
and volatility.
¾ Normally best-suited for very short-term
trades, there are also 2 longer-term
scenarios in which leveraged ETFs may be
worth considering
„ 1. Buy leveraged ETFs in strong
trending markets: Momentum and
compounding can create returns even
greater than 2 or 3 times the
underlying index
¾ Risk: If the market doesn’t trend
strongly in the direction of the ETF,
the amount invested may be at risk.
„ 2. Short matching “bull” and
“bear” leveraged ETFs in volatile
range bound markets: Leveraged
ETFs are inherently “short gamma” so
by shorting matching leveraged ETFs
one can gain from the volatility drag.
¾ Risk: If the market trends strongly in
one direction, losses can be unlimited.
ETF Strategy
Leveraged ETFs: Don’t Hold Your Beta
Leveraged ETFs Reset Daily
It’s reasonably well understood by now that levered indexes require an ETF to
rebalance at the end of each day. Effectively, the ETF is levering new gains
(or delevering for losses) from the current trading day. This is important so
that investors buying the funds tomorrow get the correct 2x or 3x beta on
their trade date (not leverage based on a prior days share price.
In our earlier reports on these ETFs (see Double Trouble & Triple Trouble) we
showed that, for a longer term holder of these ETFs, returns over the
complete holding period would almost certainly not be 2x or 3x, thanks to this
frequent releveraging. We also showed that in the underlying indexes, this
‘releveraging’ also happens - automatically!
Via our modeling of potential market return paths, we also highlighted two
important factors that longer term investors were exposed to. Since our first
report, real market events have kindly provided hard evidence of the return
characteristics of these ETFs. Specifically:
1. Long Momentum
In many instances over the last 12 months, leveraged ETFs have beaten their
beta. This is because the market has trended higher on decreasing volatility.
As a result, we have seen the benefits of positive compounding (levering or
‘doubling up’ gains on the returns in the levered ETFs.
Exhibit 1: In the past 12 months, levered ETFs are beating their Beta

Beating Beta: RETURNS (Mar 8 - Jan20)

Ticker Name Beta Index Index Beta x Index ETF
Even with the market up more than 50%: FAS DIREXION DAILY FIN BULL 3X 3 RGUSFL 72.2% 216.6% 243.8%
„ Double and triple short ETFs still BGU DIREXION DLY LG CAP BULL 3X 3 RIY 45.6% 136.7% 186.2%
SSO PROSHARES ULTRA S&P500 2 SPX 43.8% 87.6% 103.8%
have positive value. QLD PROSHARES ULTRA QQQ 2 NDX 52.3% 104.6% 123.9%
„ Double and triple long ETFs are at SDS PROSHARES ULTRASHORT S&P500 -2 SPX 43.8% -87.6% -58.8%
more than 2x and 3x their entry QID PROSHARES QQQ ULTRASHORT -2 NDX 52.3% -104.6% -62.1%
FAZ DIREXION DAILY FINL BEAR 3X -3 RGUSFL 72.2% -216.6% -93.2%
prices from a year ago Source: Credit Suisse: Portfolio Strategy
 Portfolio Strategy

This exposure profile is similar to being ‘long momentum’. In markets

Momentum & Gamma: a Practical Example trending strongly enough, the compounding of the levered index exaggerates
Despite double long & short Financials both falling in 2008, returns due to the directional consistency of returns.
a “short both” strategy was actually in losses half-way
through the year. Highlighting the exposure to momentum Trade Idea: Buy Leveraged ETFs for strong trends
(in this case a bearish trending market)
So while holding leveraged ETFs over long time periods can be a risky
Exhibit 2: Double long & short Financials in 2008 proposition, there are opportunities to gain even more than the leverage
200%
factor suggests.
PROSHARES ULTRA FINANCIALS
180%
PROSHARES ULTRASHORT FINANCI Risks – Obviously, the tricky part is predicting when the markets will be
160% Underlying Index trending strongly enough. If they don’t trend, there could be significant
140% losses due to volatility drag (described below).
120%
Exhibit 3: When Trend Could Have Benefit 3M Holders of a 3x ETF
100%

80% Triple Leveraged ETFs and Trend Contribution

60% 60% 1,800
40%
Trend Contribution to Performance 1,600
20% 50%
1,400
M a y-0 8
M a r-0 8

Ap r-0 8

Au g -0 8
D e c-0 7

Ja n -0 8

Fe b -0 8

Ju n -0 8

Ju l-0 8

S e p -0 8

40% 1,200

S&P 500 Level

Source: Credit Suisse: Portfolio Strategy
1,000
30%
Double Short = profit $100 Trend Adds to Performance
800
for 3M Holders
Double Long = loss $60
S&P 500
Short both = loss $40 20% 600

400
10%
Double Short = loss $2 200
Double Long = loss $70
0% -
Short both = profit $72 3/31/2000 3/31/2002 3/31/2004 3/31/2006 3/31/2008

Source: Credit Suisse: Portfolio Strategy

2. Short ‘Gamma’
The way the ETFs rebalance, they are always:
„ Buying at the end of an up-day
Exhibit 4: Volatility Drag Increases Exponentially For a „ Selling at the end of a down day
Constant Level of Expected Return
250% Even short ETFs need to do this, because on a down day they make gains,
200%
Realized Return
which need to be levered (so they need to get shorter). While on an up day,
Volatility Drag
Expected Return
they need to cover loses (buy to reduce shorts).
150%

100% In volatile markets, this feature can offset the momentum effect – decaying
50%
away accumulated returns. And as the markets volatility increases, this drag
on performance increases too. In Triple Trouble we showed that this decay
0%
increased exponentially as volatility increased (exhibit 4).
-50%

-100%
Previous publications have shown that we can approximate the leveraged ETF
return with the following equation:
-150%
0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200%

Volatility
Source: Credit Suisse: Portfolio Strategy ⎛ ( L − L2 ) * σ 2 * days ⎞
LevETF Re turn = (Index Re turn ) * exp⎜⎜ ⎟⎟
L

⎝ 2 ⎠

2
 Portfolio Strategy

Since the exponential (let’s call it the volatility drag) approaches 0 as its inputs
Exhibit 5: 3M Log Returns of UYG and Leveraged become increasingly negative, we can take away some important
Underlying Index observations:
3M Log Re turns of UYG a nd Leve rage d Unde rlying Inde x
„ As the leverage factor increases, the volatility drag is magnified and the
1.5
greater the index return is needed to offset this effect. Otherwise,
Red line represents 1 increasing leverage has a larger negative effect.
Beta Multiplied by
3M Index Return 0.5 „ Longs and shorts of the same leverage factor have disproportionate
sensitivity to volatility. Given the same leverage factor, a short ETF will
UYG Return

0
-2 -1.5 -1 -0.5 0 0.5 1 1 .5 be more vulnerable to the volatility drag
-0.5
„ As volatility (or variance) increases, the greater the volatility drag. Note
UY G 3M Returns Below
-1
Line Sh ow Vola ti lity Drag when the index return is 0 (i.e. a range bound market), increasing
-1.5
("G amma" loss)
volatility deteriorates performance more and more. Essentially, buying a
leveraged ETF is a form of selling volatility and vice versa.
-2
Lever aged Index Return
„ As the holding period increases, the volatility drag increases as well.
Source: Credit Suisse: Portfolio Strategy
„ Once again, we highlight that the ideal scenario for the greatest
leveraged return is when volatility is 0 and index returns are high – in
other words, a trending market as we discussed earlier.
We illustrate the effect volatility and leverage have on the “volatility drag” in
the surface charts in exhibits 6 and 7.
Exhibit 6: Increasing Volatility and Increasing Leverage Tend to Detract from Leveraged Returns

100%
100%

80%
80% Scalar
Scalar
80%-100% 80%-100%
60%
60% 60%-80% 60%-80%
0% 40%-60%
0% 40%-60%
8% 40%
8% 20%-40% 20%-40%
40% 16%
16% 0%-20% 0%-20%
24%
24% 20%
Volatility
Volatility 20% 32%
32% (Annualized)
(Annualized) 0%
40%
40% 0% 1
-1
1

48% 2
21

48% -2
63

3
126

-3 Leverage Factor
252

Days Held

Source: Credit Suisse: Portfolio Strategy

Trade Idea: Short both “bull” & “bear” ETFs Exhibit 7: Theoretical Returns on Double Short Strategy on S&P
500 With a 3M Holding Period Excluding Transaction Costs
Given the volatility decay in leveraged ETFs, one potential way Short Strategy (Theoretical Rolling 3 Month P&L)
to profit could be to sell both the long and short leveraged 100% 300%
ETFs on an index. An interesting feature of this strategy is 80%
250%
that the larger realized index volatility is, the less sensitive 60%

profit is to trend. 40%

200%
Strategy Return

20%
VIX Level

Our backtests of the strategy using double leveraged funds 0% 150%

since 2000 (see exhibit 7) showed the greatest profit potential -20%
historically when volatility was high and markets relatively -40%
100%

range bound. -60%

50%
-80%
Risks: The largest losses occurred when the markets were -100% 0%
strongly trending in one direction, especially with little volatility. 3/31/2000 3/31/2002 3/31/2004 3/31/2006 3/31/2008
Note that the size of the loss is potentially unlimited.
Source: Credit Suisse: Portfolio Strategy

3
Portfolio Strategy

Hard to Borrow?
Deep Dive into a Double Leveraged Short Trade
Clearly, this trade is not without substantial risk. So when is the ideal time to
put this strategy on?
As we showed in our report ETFs Bounce Back
Bigger Than Ever (Exhibit 8), most investors hold We’ve already established the volatility drag is greatest in a range bound, high
leveraged ETFs for a very short period of time. volatility environment. In Exhibit 8, we show the relationship between trend
This leads to a short supply in the borrow market, (index return) and volatility. As realized volatility increases, the more trend can
which would normally make it difficult to position for be offset. For example, if we expect only 15% annualized volatility in the
this trade. underlying index, the strategy loses 21% if the index returns 10%. However,
if we expect 25% volatility, the strategy returns an estimated 28% for the
However, Credit Suisse Delta One offers a facility same 10% index return. The surface map in Exhibit 8 can provide a rough
where ETF shares can be created to lend as part of
guide to putting on the trade given return and volatility expectations.
the implementation of this trade. Talk to your CS
salesperson for details. Tail Risk Evident- Plotting the historical strategy returns versus index
volatility, we find that the return distribution has a long left tail – while the
strategy was frequently profitable, there were a few scenarios where it yielded
very large negative returns. As Exhibits 8 and 9 show, the possibility of a
severe loss from a strong trending move in the market is substantial.
Exhibit 8: Estimated Double Short Strategy Return with 3M Exhibit 9: Double Short Strategy on 2x S&P 500
Hold Excluding Est. Trans. Costs
Strategy with 3M Holding Period
400% Increasing Volatility
300% 300%-400%
High concentration
200%-300%
200% of positive returns
100%-200%
Strategy Return Estimate

100% 0%-100%
-100%-0%
0% -200%--100%

-100% -300%--200%
-400%--300%
-200% -500%--400%

-300%

-400%
50% Potential for large
-500% 30%
Index negative returns
-25%
-20%
-15%
-10%
-5%

10% Volatility
0
5%

10%

15%

20%

25%

Annualized
Index Return

Source: Credit Suisse: Portfolio Strategy Source: Credit Suisse: Portfolio Strategy

Trade Costs Can Be High- While the simulations and backtests above were
done excluding financing costs, these costs are subject to market conditions
and may increase, raising the initial hurdle to profitability. For example,
Exhibit 10: Short Ultra ≠ UltraShort borrow costs for leveraged ETFs can easily range up to 4% or more
depending on which ETFs and the current market environment. In lower
$120
UltraShort volatility environments, these costs can easily outweigh returns. Due to this,
$100 Short Ultra using higher leverage ETFs and/or targeting more volatile underlying indices
$80
may be one method to offset potential costs (see our backtest on the next
page).
Share Price

$60

$40
Levered Short ≠ Short Levered Long
Simulations and historical performance highlight another feature of the
$20 leveraged Index math on ETF returns – Ultrashort ≠ Short an Ultra. The
$- payoffs from these two positions are actually quite different – thanks to the
- 140 280 420 560 700 840 980 1,120 1,260 1,400
impact of re-leveraging of the ETFs over time (see Exhibit 10).
Days

Source: Credit Suisse: Portfolio Strategy

4
 Portfolio Strategy

Backtesting with a 3 Month Trade since 2000

We looked at the performance of the strategy since 2000 using triple
leveraged ETFs on the Russell 2000. We assumed:
„ a 4% net cost of borrow (for each ETF)
Overall results „ Typical expense/management fees for the ETFs, which are essentially
„ Average return of 3.4% rebated to short sellers of ETFs
„ Median return of 4% „ a constant 3 month holding period for the sake of comparison (but with
„ Maximum return of 93% trades initiating on each day)
„ Maximum loss of 151%
„ Sharpe ratio 0.37 (0.77 since 2007) The results of this backtest are included in the exhibits below. Most
interesting is that despite being profitable more than 50% of the time, the
sharp ratio is still relatively low. This shows the importance of protecting
against trending markets (perhaps with rebalancing, or the use of options).

Exhibit 11: Trade Results Can Be Volatile (3M Holding Exhibit 12: Double Short Strategy on Triple Leveraged R2 Including Est.
Period, Not Annualized) Trans. Costs Since 2007
Double Short Strategy on Russell 2000: Rolling 3M Periods
40% 120.0%
80
Return 100.0%
80.0%
30% Std Dev 60
60.0%
40
40.0%
20% 20.0% 20
0.0%

VIX Level
Return

0
10% -20.0%
-40.0% -20
-60.0% 3M Return
0% -40
-80.0%
-100.0% R2000 3M Realized -60
Volatility
-10% -120.0%
-80
-140.0%
-160.0% -100
-20%
2001 2002 2003 2004 2005 2006 2007 2008 2009 12/29/06 6/29/07 12/29/07 6/29/08 12/29/08 6/29/09 12/29/09

Source: Credit Suisse: Portfolio Strategy Source: Credit Suisse: Portfolio Strategy

A Left Skewed Distribution of Returns

Looking at the distribution of returns, we found that the strategy returned 0-
10% nearly half the time and was profitable in general close to 70% of the
time. However, there is a long left tail so there is a possibility of large losses.
Exhibit 13: Positive Sharpe Ratio (Annualized) Past 3 Exhibit 14: Return is 0 to 10% Nearly Half the Time, But Tail Risk Significant
Years
Return Distribution of Double Short Strategy
50%
Sharpe Ratio
2.50 45%

40%
2.00
35%
1.50 30%
Frequency

1.00 25%

20%
0.50
15%
- 10%

(0.50) 5%

0%
(1.00)
-50% or

50% or greater
-50% to -40%

-40% to -30%

-30% to -20%

-20% to -10%

-10% to 0%

0% to 10%

10% to 20%

20% to 30%

30% to 40%

40% to 50%
greater

(1.50)
2001 2002 2003 2004 2005 2006 2007 2008 2009

Return Range (for Rolling 3 Month Holding Period Since 2000)

Source: Credit Suisse: Portfolio Strategy
Source: Credit Suisse: Portfolio Strategy

5
Portfolio Strategy

Credit Suisse
Portfolio & Derivatives Strategy
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