12/30/15   Leverage Is Not Symmetrical

Editor’s Corner

Ron Rowland

I was first introduced to the concept of leveraged funds with the debut of Rydex Nova (RYNVX) in 1993. Nova was the first leveraged mutual fund and was designed to provide 150% of the daily exposure of the S&P 500 Index. I immediately saw the potential of such an approach, while simultaneously being wary of the increased downside risks.

I used Nova as a source of “portable alpha” in a managed account program I developed called Index Plus. The basic concept was to put two-thirds of the portfolio into Nova, thus providing 100% exposure to the S&P 500. I was then able to use the remaining one-third of the assets in an attempt to generate increased returns.

By closely monitoring the accounts I had invested in this manner, I was able to observe the effects of the daily reset of Nova’s 150% exposure. In theory, I would need to rebalance these portfolios every day in order to keep the 66.6%/33.3% balance between Nova and the other investments. In practice, I found I could stretch the rebalancing interval out to a month or more with minimal impact. However, I did notice that rebalancing became more critical during downward-moving markets. The compounding effects of resetting the leverage on a daily basis meant that Nova’s long-term performance would not be equal to 150% of the S&P 500. Additionally, it would exacerbate the downside moves.

Even though I have been using leveraged funds for more than 20 years, I still find myself in awe of the short-term performance swings these instruments can achieve. Perhaps “terrified” is a better one-word description. Today, there are numerous ETFs providing 2X (200%) and 3X (300%) long and inverse exposure. The 150% exposure of Rydex Nova looks almost nonexistent compared to these highly leveraged funds.

There have been only three-and-half market days since last week, but in that short span of time, some nearly unbelievable moves have occurred. If you were lucky enough to own the VelocityShares 3x Long Natural Gas ETN (UGAZ), it soared 59.4% higher. However, if you were betting on continued declines in natural gas stocks with the VelocityShares 3x Inverse Natural Gas ETN (DGAZ), then you were holding a security that plunged 44.0%.

On first glance, the 44.0% drop for DGAZ may seem small compared to the 59.4% rise of UGAZ, but that is where the daily reset of 3X leverage and the mathematics of negative percentages can create a mirage. To get back to the same levels they were at just a week ago, UGAZ would need to drop 37.3% and DGAZ would need to zoom 78.7% higher. Leveraged investing is not symmetrical—it is a double-edged sword with the downside edge being more brutal. However, it sure feels good when you are on the profitable side of a trade.

Investor Heat Map:12/30/15

Sectors

All sectors improved, with most posting double-digit increases in their momentum scores. Bottom-ranked Energy and Materials boasted the largest gains, but it wasn’t enough to move them out of the red or off the bottom. Four sectors did manage to transition from red to green, and they were Technology, Financials, Industrials, and Consumer Staples. There were not any significant changes in the relative-strength ranking, although Real Estate did move one notch higher to take first-place honors away from Consumer Staples. Telecom and Health Care also swapped positions, with Telecom claiming a slight edge this week. By pure coincidence, our first sector ranking of 2015 looks much like today’s last ranking of the year. When 2015 got underway, Real Estate was on top with Utilities, Health Care, and Consumer Staples rounding out the top four. Plus, just like today, Energy was in last place and Materials was only one notch higher, and both were in the red.

Styles

The style categories also showed noticeable improvement over the past holiday-shortened week. All but one posted double-digit gains in momentum scores. The one “slacker” was Large-Cap Growth, and its nine-point improvement moved it from red to green, leaving it solidly in second. Large-Cap Blend and Large-Cap Value also transitioned from negative to positive momentum, maintaining the dominance of larger capitalization stocks over their smaller brethren. For the seven categories remaining in the red, their scores are compressed within a four-point range. Additionally, there is a virtual four-way tie for last place with Micro-Cap and the three Small-Cap categories posting identical momentum values. Unlike the sector ranking’s similar lineup at the start and end of 2015, today’s style rankings are completely inverted from their beginning of the year lineup, which had Micro-Cap at the top and Mega-Cap at the bottom.

Global

The global categories improved this week, but not to the degree seen in the sector and style rankings. There were some big changes, however, starting with Pacific ex-Japan’s jump from fourth to first. Having Pacific ex-Japan at the top seems like a rare event to me, so I went back and searched the archives. Indeed, the last time Pacific ex-Japan was the top-ranked global category was in February 2013, which was 149 weeks ago. It climbed as high as second in October 2013 and again in April 2014, but it has been relegated to the lower half for much of the past two years. As a reminder, this MSCI classification consists of just the four developed market countries of Australia (59.8%), Hong Kong (27.4%), Singapore (11.2%), and New Zealand (1.4%). New Zealand has been the best performing of the four, but its 1.4% allocation has little impact on the region’s overall results. Pacific ex-Japan’s new-found strength is mostly due to the bump in Australia’s stock market the past few weeks and the increased strength of its currency. A week ago, all 11 global categories were in the red. The U.S. swapped places with Japan, and both moved to the green side of the ledger this week. China was the big downside mover, dropping from its first-place perch of a week ago down to fifth this week. The U.K. had a strong week, allowing it to move ahead of Emerging Markets. The bottom-three categories now consist of Emerging Markets, Canada, and Latin America. Few similarities exist between now and the beginning of the year in the global rankings, with the major exceptions of the U.S. being in second with a small positive score and Latin America being at the bottom with a large negative reading.


Note:
The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“Give me a lever long enough and a fulcrum on which to place it,
and I shall move the world.”

-Ancient Greek mathematician Archimedes (287 B.C.–212 B.C.)


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