Today we thought we’d explore the nuances of daily leveraged ETFs, the so called ‘volatility drag’ they impose and if/how futures are a better vehicle for leveraging for retail traders. This post was inspired by questions one of our subscribers asked so we thought it might be worth turning it into a blogpost 🙂
Do futures even track the underlying well?
Even before we go to the pros and cons of investing in futures, we should answer a basic question. Over a long enough time period, do futures even track the underlying ETF we’re trying to replicate well? Think investing in /ZN instead of IEF at 1x notional amount (yes they’re not exactly the same because the DV01 of futures is different than the average maturity of IEF but we’re not going into minutia right now). Now because futures require so little upfront capital, we always want to park our remaining cash in short-term treasuries instead of pure cash. In our backtesting, replacing certain tickers with their futures-rolled equivalent adjusted index and the results have held up pretty similarly. There’s also been independent work done (here for example) where people have backtested holding and rolling futures long-term at leverage 1.0 and comparing against the benchmark, they’re pretty much the same for most cases.
Theoretical difference between futures and daily-rebalanced leveraged ETFs
Gaining leverage through futures is similar to gaining leverage through borrowing/margin. Meaning the leverage doesn’t stay constant day-in-day-out. It gets reset to whatever you reset it to when you trade it. This is not true for daily-rebalanced leveraged ETFs which reset their leverage to an exact number everyday.*
Let’s take an example. You want to run $100 at 3x leverage. Buying daily-leveraged ETFs would mean a market return streak of -1%, +1% would yield $100 * -3% = $97 dollars on the first day and then $97 * +3% = $99.91 on the second day. This is the volatility decay which happens at a 3x rate rather than 1x rate people talk about with leveraged ETFs. However this ‘decay’ can work in your favor too. If we had +1% and +1% returns, on the first day we’d have $100 * +3% = $103 and on the second we’d have $103 * +3% = $106.09.
Now let’s see what happens if we use futures. If we run $100 at initial leverage of 3x, it’s basically us buying $300 dollar worth of futures with our $100. Now a -1% and +1% would yield $300 * -1% – ($200 borrowed dollars) = $97 on the first day and then $297 * +1% – ($200 borrowed dollars) = $99.97 dollars at the end of the second day.
Notice how we ‘decayed’ 3 cents in the futures case but 3*3 = 9 cents in the leveraged ETFs example. So because of daily resetting, our decay rate is 3 times that of non-daily resetting. But again, like mentioned, in a +1% and +1% scenario, the futures would give us $103 on the first day and then $303* * (+1%) – ($200 borrowed amount) = $106.03 dollars. Again notice how we gain 3 cents in the futures case but 3*3 = 9 cents in the daily rebalanced case. So ‘volatility decay’ isn’t necessarily a decay, just a heightened impact of volatility which is multiplied by the leverage ratio you’re attempting to use.
More so than decay though, notice that in the futures case we are borrowing a fixed dollar amount meaning our leverage percentage is shifting with time instead of remaining at a fixed 3x. So at the end of the first day in -1% case our leverage ratio for futures is now 297/97 = 3.06x and in +1% case our leverage ratio for futures is 303/103 = 2.94x.
In practice, all this usually balances out over longer periods of time unless the instruments being used are super volatility (which gives a benefit to futures as volatility decay doesn’t happen as often) or if there’s a huge nosedive and you’re too highly levered (which gives a benefit to daily-rebalanced ETFs because you’re not increasing leverage in a nosedive which is dangerous). For our strategies in particular it doesn’t matter too much because whenever you’ll trade, you’ll try to manually rebalance the futures notional amounts to ‘reset’ the leverage for futures to what you want them to be.
Pros of holding futures:
The biggest pro of holding futures is favorable tax treatment if you’re a high earner with a high short term capital gains tax rate and you’re trading in a taxable account. All our strategies are pretty high turnover, meaning if you trade them in a taxable account you’d probably incur most gains as Short Term Capital Gains. The beauty of the futures that we trade is that they are 1256 contracts that are taxed as 60% Long-term tax rates and 40% Short-term tax rates. There’s no holding period requirement at all to get this tax treatment, even if you hold it for a single day.
This is very useful in terms of levering up instruments whose 3x counterparts aren’t that liquid. Think IEF being traded through /ZN futures (much more liquid) rather than TYD.
Less embedded fees and leverage fees
There’s no expense ratio at all. Also, the cost of carry/leverage embedded in futures contracts is probably the lowest a retail investor can get, as it’s close to the risk free rate (think three month treasury / LIBOR rate etc.). The cheapest margin we’ve seen for retail investors is on Interactive Brokers, but even they charge 1-1.5% above their advertised Benchmark Rate.
Cons of holding futures:
Large account size needed, not easily divisible
This is the catch 22 of futures investing for retail investors, especially those without large account sizes. Some of these contracts, especially treasury futures have a notional value of $130000-140000. Meaning even if we’re talking about 3x leverage, the most granular we can get is around $40000 increments. Now assume you have $60000 capital you want to run at 3x leverage in /ZN. You can either buy 1 contract, which will give you approximately 2x leverage, or you can buy 2, which will give you around 4.5x, there’s nothing in between. This has improved for some futures with the introduction of Micro futures and initiatives like the Small Exchange, but is still the biggest hurdle for getting started in futures.
Some of these contracts have physical delivery rules, so you have to be careful about rolling them before they expire. This basically means more trading/slippage. This isn’t that big of a deal with our strategies though as they’re high turnover so you were probably going to trade soon anyway, thus the additional impact of rolling isn’t that high.
This is a recent con now that ETF trading is free everywhere (though one could argue you’re getting worse fills for ETFs with order flow being sold to high frequency firms). Futures trading still costs around $1-$2.25 per contract. Again I would say this is a drop in the bucket because the notional amount of most futures is so large this is negligible.
Hopefully this was a good whirlwind tour of why future contracts might be a good replacement for daily leveraged ETFs in taxable accounts depending on the pros and cons of one’s situation, the speed at which a strategy trades, and one’s tax situation.
*A good exploration of daily rebalancing for leverage and volatility drag can be found here.