A simple strategy to beat the S&P 500, beware of the risk

There is an instrument in the financial world, a member of the ETF family that has beaten and can beat the performance of the S&P 500. We are going to talk about this magical ETF and it’s little, less risky, sibling.

Who is this magical ETF?

It is called the SPXL, the SPXL is a leveraged ETF that provides 3x the daily return of the S&P 500, this means that if the S&P 500 increases by 1% in a day, the SPXL should increase by 3%.

SPXL inception date was 11/05/08 and since that day to 02/28/21 it produced a return of 1,792% which is more than 5x the return of the S&P 500 in the same period (310%).

Let’s take a look at the behavior of $10K invested in each

Looks like an extreme but rewarding ride.

But, and there is always a but…

As we saw in the previous graph, in March 2020 you would see your investment drop from 178K to 41K (~77% loss), which can scare you enough to sell before getting to the full return.

But there is even more risk involved, since SPXL has a leverage of 3, a decline of more than 33.33% in one day would wipe out all your money.

For this strategy to work, the real question is whether that drop is likely to happen or not.

Can the S&P 500 drop more than 33.33% in a day?

Let’s have a history lesson before answering the question:

The largest daily loss for the S&P 500 has been 20.5%, it was the Black Monday on October 1987, prior to it, the largest daily drop was of 12.3% in times of the great crash (1929).

For people before October 1987 a drop of 20% would seem impossible and a 4X leveraged ETF might looked like a good idea with the argument of “that has never happend”, after October 1987 the good idea may not be that good.

In 2008 we had another lesson of “that has never happened” with the subprime crisis.

History makes us conclude we can never relate in “that has never happened” to assess the risk of an investment.

The risk we are assessing is that of an extreme event, an event where the S&P 500 is down more than 33.33% in a day and has never happened, then, we can’t use the common risk metrics.

The interesting fact is that we cannot be certain of the probability of such an event and our only option is a less rigorous analysis, more personal to each individual.

Assessing the risk

The questions one should answer in order to know if this kind of risk is tolerable are:

1. How likely I think is a fall of more than 33.33% in one day for the S&P 500?
2. If tomorrow the S&P 500 falls more than 33.33% and I lose this position, would it hurt my portfolio in a way I cannot stand?
3. If someday in the future this position has an accumulated return of +1000% and the next day the S&P 500 falls more than 333.33%, would it hurt my portfolio in a way I cannot stand?

For me the answer for the first question is not so likely, but I think it’s going to happen someday.

My answer for the second question is yes, since I would allocate lessthan 5%.

However, the answer to the third question is pretty important, because that return would drive this position from 5% to ~18% of my portfolio and I can’t stand a permanent loss of 18% since I find this scenario likely in some future crisis.

As I said, the answers are personal for every investor and mine should not be taken as the only answers.

I don’t love risk that much

I am not so risk tolerant, that’s why I am going to introduce the little sibling of SPXL, which involves less risk and as a consequence, less return.

SPUU is the name, It was launched in 05/28/2014 and provides 2x the daily leverage of the S&P 500. Since inception it produced a return of 169% which is 1.6x the return of the S&P 500 (104%).

Let’s plot the $10K investment graph with this one

Before answering the questions, we should note that the drop in S&P 500 daily return to wipe out the investment in SPUU is not more than 33.33%, is more than 50%.

Now, the questions:

I think someday the S&P 500 might drop more than 50% in one day, however, if it ever happens, it might be a really huge crisis where other things might be more important.

If this happens tomorrow, I won’t worry too much about my portfolio since I would not allocate more than 5% to SPUU.

The return might turn a 5% position into a ~10% position, however, this time I am willing to lose 10% of my portfolio since I think this scenario is close to doomsday for markets and as such I might not even live to see it.

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.