CPM Investing LLC - Research Publications
A distinctive feature of some Focused 15 Investing model portfolios is the inclusion of ETFs that magnify the returns of the indexes they track. These are most commonly called "leveraged," “levered,” or “geared” ETFs.
An ETF that gives twice the returns is often referred to as a 2x or x2 ETF. Many Focused 15 model portfolios use the ETF “DDM” managed by ProShares. This ETF tracks the DJIA but gives us two times the return (up or down) of the DJIA each day. ProShares uses the term "geared" when referring to this ETF.
By using a levered ETF for the DJIA, we can magnify the returns of high-quality companies with very liquid stocks to a level of return promised by other investments. But in doing so, we also maintain the advantages of high quality and liquidity (the ability to buy or sell the ETF when desired and still get fair pricing) of the DJIA companies.
Many investors take on liquidity risk or buy lower-quality investments in order to gain higher returns, but that can result in lower returns during times of financial stress. In these situations, trading for some investments is limited and occurs only when prices have been reduced and when lower-quality investments perform poorly because of higher uncertainty about their viability going forward. We avoid situations like this by basing our model portfolios on ETFs based on the DJIA.
Just before the Global Financial Crisis of 2007-2009, I started managing a global asset allocation mutual fund that had been designed by the Tokyo office of the company I worked for. The fund had investments all around the world to promote greater diversification and get higher returns – both attractive qualities to fund-buyers and the marketing style of the early 2000s.
In 2008, the MRI-based system (an early version of our current Focused 15 approach) indicated that the fund should get out of a few of the markets outside of the US. Unfortunately, some of those investments simply could not be sold, even at a very low price – there were no buyers for what we wanted to sell from the fund. In this case, the global search for higher returns had led to investments that ultimately did not serve the objectives of the fund.
After that experience, I developed a strong preference for magnifying the return of high-quality and liquid investments rather than investing in assets that seem to have a good story of a bright future during strong economic times. Unfortunately, that promise often comes with a lack of liquidity in times of crisis.
The 30 DJIA companies are the highest-quality companies in the world, are widely traded, and are very liquid. There is very little chance that we will not be able to trade our DJIA-related ETFs when we want to do so. This prediction has been borne out during the pandemic-induced sell off and rebound during early 2020.
Also, while their prices may drop, the stocks of the DJIA companies are less likely than many other companies to go out of business and have their stocks go to zero in price. The companies have been selected by the editors of the Wall Street Journal for their strength and industry leadership. See this link for membership: https://marketresilience.blogspot.com/p/etf-holdings.html.
They are large companies with proven businesses in multiple markets and tend to have good access to funding in times of economic stress. The DJIA has recovered from major price declines throughout its history, including the great Depression, two world wars, periods of high inflation, and periods of low growth. The index is very likely to recover after price declines and to participate in any global growth recovery.
Diversification is important, though, and so I would like to point out that these 30 companies are themselves globally diversified. Among the 30 are 3M, Caterpillar, Disney, Procter & Gamble, and Microsoft, and such companies tend to be globally diversified businesses. Thus, our portfolios will participate in global growth but will do so through the highest-quality companies available. We may miss some faster-growing major local players in Europe or Asia, but our prudent use of leverage allows us to get similarly high returns without sacrificing quality and the ability to achieve the objectives of loss avoidance in our model portfolios.
We also use ETF “UST,” which magnifies the return of the US 10-Year Treasury bond [HH4] [J5] indexes. The US 10-Year bond is the bond equivalent of the DJIA companies: high-quality and widely traded. Over the last 10 years, there have been periods when professional investors have been concerned about being able to sell high-yield and emerging market bonds and the ETFs that track them. We are unlikely to have these problems with the ETS UST.
How ETF Managers Get Paid for Return Magnification
Some subscribers have asked how the ETF providers can afford to give two times the return of the index they are tracking. Levered ETFs have higher fees. The fee (expense ratio) for DDM is currently 0.95% per year, but there is typically an additional fee for the leverage. As a comparison, the expense ratio for ETF "DIA," which also tracks the DJIA but does not magnify returns, is 0.17%. The manager of the levered ETF arranges with large banks to obtain the magnified returns (for an additional fee). The fee varies over time, and I assess the total impact of fees two times a year. When we use these leveraged ETFs to magnify the returns of high-quality and liquid investments, I believe the benefit we get from the magnification far exceeds the cost.
Although Focused 15 Investing subscribers may be instructed to sell out of ETFs from time to time, it is helpful to remember that because we are trading widely-held investments and liquid investments, when we are selling, someone else is buying, and the ETF manager always collects its fee. Thus, the ETFs managers (with help from banks) continue to offer the return magnification. Furthermore, keep in mind that the banks providing the magnification to the ETF manager are large, have long investment horizons, and manage their overall risk to the markets in a collective manner across all their relationships.
Overall, the levered ETF "DDM" is more expensive than DIA. However, in our model portfolios, we derive great benefit from the magnification of the returns from these high-quality companies with liquid stocks and bonds.
Using this ETF in Focused 15 model portfolios allows us to address the known bias of underperformance of our loss-avoidance signals in the late stage of an ascending market. It also allows us to bring portfolio variability close to that of the DJIA, which has a fairly low level of variability overall, while we still achieving higher returns—thus creating a more compelling and beneficial Return-to-Variability ratio for our subscribers.
Please view the video for more information on levered ETFs and more technical detail. The video describes more specifically what we achieve with the use of leverage and how the typical level of leverage was determined.