What's up guys and welcome to wall street millennial before we get into the video, keep in mind that we are not financial advisors and this video is for entertainment purposes, only make sure you do your own research and consult with a professional before making any investment decision. This video is not an endorsement of any investing strategy or product. No financial advice should be taken from this video. The stock market is widely considered the greatest tool of wealth creation in human history.

Since 2008, the stock market has seen a tremendous recovery increasing at a compounded annual return of roughly 15. This means that, if you put in 100 into the spy and reinvested the dividend, it would have turned into 570 today. However, what if i told you if there is another investment strategy that massively outperformed the s p in the past decade, the blue line represents an alternative strategy and the red line represents the spy. As you can see, the spy's returns look minuscule compared to the blue line.

If you invested 100 into the spy and the alternative strategy in 2008, the 100 in the spy would have turned into 570. Today, however, this is dwarfed by the 2 700. It would have turned into with the alternative strategy. So what is this investment strategy? Is it warren buffett's godly stock picks? Is it a complex hedge fund strategy? It is actually an extremely simple strategy that is not either of those two.

The investment strategy that outperformed so much over the past decade is simply the direction daily s p: 500, both 3x leverage, etf, ticker, symbol, spxl, the spxl seeks daily performance of 300 of the daily performance of the s p 500 index before fees and expenses. Importantly, the fund does not seek to achieve this 300 target for a period of time different than one trading day. We will get into exactly what this means later. Spxl achieves its leveraged daily returns by investing in swap agreements in futures contracts, which are intended to produce economically leveraged investment results.

By using these financial derivatives, they achieve the desired exposure without technically owning shares in the spy. You might remember bill huang used a similar strategy to gain massive amounts of leverage in viacom and other stocks for his hedge fund archaicos. When evaluating any etf, it is important to look at the fee structure. Spxl charges a management fee worth 0.75 of the invested amount on an annual basis.

They also incur transaction costs and other operating expenses that they pass through to the holders of the etf. These transaction fees may vary, but they cap the total amount of fees at 1.01. As reported by investopedia, the fees are deducted from the net asset value of the etf on a daily basis. You won't see the fees on your brokerage statements, because the etf manager handles them.

In-House spxl will not exactly hit its 300 target every day, because there is a tiny amount shaved off each day for the fees. Also, the derivatives position that they enter into each day are subject to small sizing errors. However, it generally comes very close to the 300 target on any given day. There are many resources on the internet, explaining the effects of three times daily leveraging on etfs for investor returns.

Most of them say that three times leveraged etfs are bad, long term bets and shouldn't be used by long-term investors. They cite discrepancies and performance between the 3x leverage etfs and what you might expect from them, for example, in this investopedia article, the performance of not even a three times leveraged etf, but just a two times leveraged etf on the smp. The sso is compared to the performance of the s p. The article says that the s p was up 3.6 in one year in 2009, while the leveraged etf was not up twice, the s p and was in fact down slightly over the course of that same year.

Leveraged etfs are rebalanced daily, so the three times ratio should not be expected to be maintained over periods of time more than one day. As a result, the positive 3.6 return of the s p 500 over the course of 2009 should not make an investor expect that the two times leveraged counterpart would have two times a positive return or 7.2 percent. However, that should be well known by educated investors. So, let's take a closer look at why these articles say that this phenomenon exists.

The reasons commonly given for the lacking performance and three times leveraged etfs in certain market conditions are usually explained by theoretical examples in this motley fool article. The author asks the reader to consider a stock index that starts at one hundred dollars. In the example, the index falls. Twenty percent on the first day, then rallies by twenty percent.

On the second day after the two days, the index price is back up to 96 dollars for a minus four percent. Total return. On the other hand, a three times leveraged etf tracking the same index would be down sixty percent on the first day and up sixty percent. On the second day.

The total return would be a net loss of 28, that's much greater than three times the loss of the original index. The investopedia article also explains this phenomenon. This is called volatility drag. The article goes through another, almost identical example, with the two times leveraged sso etf.

This type of example, where an index goes down a percentage on one day and then up the same percentage on the next and the resulting severe underperformance of the leveraged etf is a classic example used to tell people that leveraged etfs are inherently underperformers. So now, let's investigate these claims to see if they actually mean that long-term investors shouldn't use leveraged etfs. The daily rebalancing of the leveraged etfs means that over the long term, a three times leveraged etf will not give three times the results of the underlying index. There are many articles, including two that we just saw that gave examples of when the leverage etf will severely underperform the daily leverage ratio.

But then why is it that the three times leverage s p 500 etf? The sp xl is up more than 2 300 since inception in november of 2008, while the unlevered spy etf is up only 338 in the same period. That means that the three times leveraged etf actually outperformed the underlying index by a factor of seven, which is actually even better than the three times positive return of the spy by a long shot. So clearly, the volatility drag doesn't always hurt investors. Now you might say that that's an unfair comparison, because the same period since spxl was started was one of the longest and most intense bull markets in history.

Later in this video, we'll do a study looking all the way back to the 1920s before the great depression and see what happened then. But if we look at another leverage etf, the two times leveraged sso, it was made back in june of 2006 right before the great recession. It is currently up 523 since inception. In the same period, the underlying s, p 500 index has experienced the 2008 financial crisis and the coronavirus sell-off and yet the two times, leverage etf, is still up significantly.

In fact, again it outperforms the two times daily leverage ratio returning 523, as opposed to 230. For the spy, that's an outperformance of 2.27 times which, like the 3x leverage, etf, actually outperforms the nominal daily leverage ratio since inception. The reason is that the daily rebalancing of the leveraged etfs is not an inherently money-losing process. There's an entire academic field of mathematical statistics devoted to studying random processes, which includes real-world phenomena like stock prices.

This field of study has produced some very powerful mathematical theorems that can explain what is happening with the three times. Leverage etfs one of the most important results in the field is the optional stopping theorem. This mathematical theorem was developed by the preeminent mathematician from harvard joseph dube. The actual theorem requires advanced measure theoretical probability theory, but you don't need to know how the theorem works to apply it to the stock market.

Essentially, the theorem says that if you have a fair random process, such as a stock price, that on average will return 0 on each time step, then no matter what your exit strategy is. Your average return will be equal to the average return of the underlying process. What that means is that say, for example, the stock market on average returns eight percent per year, then you can construct a process equal to the stock market, return minus eight percent each year, and that will be a fair process with zero expected return. Now multiply their returns each day by three times, leverage like the leverage, etfs and subtract eight times three or 24 percent each year.

This process is also a fair process with zero expected return. The optional stopping theorem then tells us that, no matter what strategy you use to eventually exit the trade, your strategy's returns on that fair process will, on average, be zero, because that process is the returns of the three times leveraged stock market minus 24 annually. That means that the expected return of the three times leveraged stock market will be 24 on an annualized basis, no matter what your exit strategy is, so theoretically, on average, before expenses and management fees a three times, leverage etf should return exactly three times the return of The underlying index, that is a mathematical fact, based on certain assumptions on the stock market. If you want to know what the exact details are, the assumptions include that the underlying stock index is something called a discrete time.

Martingale and your trading strategy is subject to information. Only available up until the current time, in other words, you can't look into the future. However, the investopedia article on leverage etfs also brings up a separate point about leveraged etf expense ratios being high. For example, the spxl three times leverage s p 500 etf, says in his prospectus that the total annual fund operating expenses after expense, cap and reimbursement is about 1.01 percent.

This is a very high expense ratio for an etf even higher than the arc innovation etf, which has an expense ratio of 0.75 per year. However, because the holdings of the leverage etf are very complicated and have to do with financial derivatives and leverage, the actual expenses of the leverage, etfs may be more or less than the stated amount to show the impact of the fees we simulated. The returns of a three times leveraged position in the spy with no fees to do this, we simply multiplied. The daily returns of the spy by three the yellow line is the returns of the unlevered spy.

The blue line is the returns of the sbxl, and the red line is a simulated return of the three times daily leverage etf with no fees. The starting point is november of 2008, which is the inception date of sp xl. As you can see, without fees, the returns are significantly higher than the spxl. The compound and annual return of the spxl is 32.5.

This is 4.4 lower than the compounded annual return of the no fee simulation, which is 36.9 over time. The fees are a significant drag on the performance, even taking into account the fees. The returns are still far superior than the unleveraged spy. The spxl was formed in november of 2008, almost exactly at the market trough of the great financial crisis.

After this, the market achieved a historic bull run and the spxl benefited tremendously. Obviously, past performance does not guarantee future performance in periods where the spy does not perform well. The returns of spxl will be much lower. Yahoo finance provides daily price data for the s p.

500, going back almost 100 years to 1927.. With this data, we can simulate the hypothetical returns of spxl going back to 1927.. This will allow us to see how it held up during financial downturns, such as the great depression and dot-com bubble of 1999.. This bar chart shows the yearly returns of the s p 500, as well as the hypothetical returns of a daily three times leveraged etf.

We subtracted the fees from the three times leverage returns, so it should give a pretty accurate simulation of what the spxl's returns would have been had it existed back, then the blue bars represent the yearly returns of the s p. While the orange bars represent the yearly returns of the three times, leverage etf, the returns of the leveraged etf vary dramatically over time. During the great depression, the stock market performed very poorly from 1929 to 1932, the market had four consecutive down years. In 1931, the s p fell almost fifty percent the three times leveraged etf declined roughly ninety percent.

During the fifty years following the great depression, the three-time leverage etf did pretty well, it had positive returns in most years, its best year ever was 1954, where it achieved a return of approximately 190. In the 90s it had a few very good years as a dot-com bubble was inflating in the early 2000s. It had three consecutive terrible years as the bubble burst, as you would expect. 2008 was one of the worst years for the three times: leverage strategy, the markets tanked by about 30 percent and the three times leveraged strategy lost almost 90 percent of its value during the post-recession recovery.

The three times leveraged strategy did very well posting large gains in most years by looking at the 100 year history. It is obvious that the three times leverage returns are highly volatile. During protracted bear markets, it can see multiple years of horrible returns that wipe out nearly all of its value. The returns are highly dependent on when you initiate the position.

If you invested in the three times leveraged etf right before the great depression, it would have been a disaster and you would have lost almost 100 of your initial investment on the flip side, if you had first invested in 2008, you would have made a 23 bagger On your investment during the post recession recovery, so we've seen that during certain market conditions, the three times leveraged etfs can far outperform even three times the long-term results on the market, but in other market conditions it can almost bankrupt its investors. It all depends on when the investment was made. For example, the three times leveraged position right before the great depression would have nearly bankrupted. An investor which of these two scenarios happens, depends on the timing of when the investment in spxl was made.

However, one of the most important concepts in investing is well known to be. Diversification and diversification can actually reduce the risk of three times leveraged etf's, bankrupting investors. Diversification does not just apply to buying multiple different stocks; it can also be applied to when you enter an investment. In other words, an investor can diversify through time by instead of buying in one big tranche, buying a set amount each month or each year to see how well such a strategy would have worked.

We used the simulated 3x leverage etf for the same effective fees that we observed in spxl, going back to 1927 before the great depression. Let's say you were to invest 100 each year into a theoretical, 3x leverage, s, p, 500, etf after expenses and fees, even through the great depression which would have bankrupted a one-time investment. This strategy would have made an investor rich. This investment plan would have left an investor with a fortune of about 13 million dollars by 2021, whereas a recurring investment in the unleveraged s p would have left the same investor with less than half a million.

It's true that there would have been multi-year periods of severe underperformance, especially during times like the great depression and the 1987 flash crash, but over a long period of time. In this case almost 100 years, the three times leveraged position would have outperformed. The total return of the unleveraged counterpart by an incredible margin, so the bottom line is that three times daily leveraged etfs are not what they seem at first. They use financial derivatives to obtain the three times daily return of their underlying index.

This has unintuitive effects in the long term, which can cause their performances to severely underperform the underlying index in certain market conditions or, as we've seen severely outperformed the same underlying index and other market conditions. A three times leveraged s. P 500 etf can easily bankrupt an investor as it would have done if it existed back in the great depression, but sometimes it can lead to long-term returns that are many times more than three times the return of the underlying index. Obviously, they are extremely risky investment vehicles that should not be used for long-term investing of money that an investor cannot afford to lose.

But it is interesting to study the mechanics of how these leverage etfs work and what it means for long-term investment returns. All right guys that wraps it up for this video, if you like the content, make sure to hit that like button and subscribe for future uploads, also check out our second channel wsm research, where we post due diligence on high growth tech talks. In the meantime. Thank you guys so much for watching and we'll see in the next video wall street millennial, signing.

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