The industry’s first 1.25x ETF
In January 2015, Direxion introduced the first 1.25x daily S&P 500 ETF, Direxion Daily S&P 500 Bull 1.25x Shares (NYSEARCA:LLSP). This is an interesting product because it is provides an opportunity to increase expected returns (and volatility) rather modestly, at least compared to existing products that aim for 2x or 3x daily gains. LLSP has a net expense ratio of 0.35%.
The purpose of this article is not to debate the merits of leveraged funds or the optimal leverage factor, but to examine whether Direxion’s “lightly leveraged” ETF has accomplished what it set out to accomplish. As the article title suggests, it has not.
According to Yahoo Finance, LLSP has net assets of only $6.87 million. Since inception on January 9, 2015, its mean trading volume is 6207 shares/day with a median 200 shares/day. On 142 of 408 trading days (34.8%), trading volume was zero.
Figure 1 shows the relationship between daily gains for LLSP and SPY since LLSP’s inception.
LLSP’s R-squared is 0.44, indicating very poor tracking of 1.25x daily S&P 500 gains.
Notably, Direxion’s 2x and 3x S&P 500 ETFs, SPUU and SPXL, have extremely high R-squared values: 0.94 and 0.99, respectively.
LLSP’s beta should be right around 1.25, but in fact it is 0.88. So in essence this “lightly leveraged” fund is acting as a de-leveraged fund.
Again, Direxion’s 2x and 3x funds have acceptable betas of 1.93 and 2.94.
Low Sharpe ratio
A leveraged ETF should have a Sharpe ratio very similar to its underlying index. In practice, two forces result in leveraged ETFs having slightly lower Sharpe ratios: (1) Higher expense ratio; (2) Extra variability due to tracking error.
LLSP’s net expense ratio is not bad at all, at 0.35%. However, its tracking error is huge. So it is not surprising that its Sharpe ratio since inception, 0.021, is much worse than SPY’s over the same time frame, 0.031.
Direxion’s 2x fund has a Sharpe ratio of 0.028 since inception (SPY: 0.036), and its 3x fund has a Sharpe ratio of 0.046 since inception (SPY: 0.048).
Turning gains into losses
Figure 2 shows growth of $10k in SPY, LLSP, and an ideal 1.25x S&P 500 ETF since LLSP’s inception. While a 1.25x fund should have generated additional gains relative to SPY over this time period, LLSP actually underperformed SPY.
A Simple Alternative
Fortunately, you don’t need to use a 1.25x leveraged ETF to achieve 1.25x leverage. A simple solution is to combine a 2x or 3x leveraged ETF with cash, as described in Build Your Own Leveraged ETF.
I would recommend using a 3x ETF, e.g. SPXL or ProShares UltraPro S&P 500 (NYSEARCA:UPRO). If you allocate 5/12 of your assets to the 3x fund, and hold the remaining 7/12 in cash:
Net beta = 5/12 x 3 + 7/12 x 0 = 1.25.
Rebalance periodically, say once a month or whenever the effective beta falls outside (1.20, 1.30).
If you want 1.25x leverage, avoid the disaster that is LLSP and simply combine a 2x ETF or 3x ETF with cash proportionally.
In fact, with this approach, you don’t have to choose exactly 1.25x leverage. You can choose 1.1x leverage, or 1.5x leverage, or really anything between 0 and 3.
Disclosure: I am/we are long UPRO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Unique Finance). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author used Yahoo! Finance to obtain historical stock prices and used R to analyze the data and generate figures. Any opinion, findings, and conclusions or recommendations expressed in this material are those of the author and do not necessarily reflect the views of the National Science Foundation.