I think this post contains many errors/issues (especially for a post with >300 karma). Many have been pointed out by others, but I think at least several still remain unmentioned. I only have time/motivation to point out one (chosen for being relatively easy to show concisely):
Using the 3x levered TTT with duration of 18 years, a 3 percentage point rise in rates would imply a mouth-watering cumulative return of 162%.
Levered ETFs exhibit path dependency, or “volatility drag”, because they reset their leverage daily, which means you can’t calculate the return without knowing what the interest rate does in between the 3% rise. TTT’s website acknowledges this with a very prominent disclaimer:
Important Considerations
This short ProShares ETF seeks a return that is −3x the return of its underlying benchmark (target) for a single day, as measured from one NAV calculation to the next.
Due to the compounding of daily returns, holding periods of greater than one day can result in returns that are significantly different than the target return, and ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks.”
You can also compare 1 and 2 and note that from Jan 1, 2019 to Jan 1, 2023, the 20-year treasury rate went up ~1%, but TTT is down ~20% instead of up (ETA: and has paid negligible dividends).
A related point: The US stock market has averaged 10% annual returns over a century. If your style of reasoning worked, we should instead buy a 3x levered S&P 500 ETF, get 30% return per year, compounding to 1278% return over a decade, handily beating out 162%.
1) For what it’s worth, volatility decay will tend to enhance returns in a bull market for the same reason it exacerbates losses in a bear or sideways market. This means in a rising rates scenario I would actually expect an inverse leveraged ETF to do better than a margin account that shorts treasuries with the same leverage. This actually just happened in 2022.
This is a counterexample to the numbers Wei Dai posted, to show that volatility decay is not necessarily always harmful.
That said... 1) The article recommends financial instruments that are extremely volatile, as the percentage gains and losses I posted above indicate. 2) Long term treasuries have ~5% gains/year historically, so shorting long term treasuries under normal circumstances means you will keep losing 5% every year (or 15% if you are 3x).
As I said earlier, volatility decay on its own is not the worst thing in the world if you have positive expected returns. But if you combine volatility decay with extremely high volatility and historical negative returns, I do believe that would make it a risky combination. I ultimately agree with Wei_Dai.
2) 2022 and the 1970s showed that inflation or nominal GDP growth can wreak havoc on asset values.
The discussion here is on real rates though, not nominal rates. Do we examples of rates rising in a low inflation environment? Yes! I came across a couple while browsing another forum a while ago. I will copy the relevant post below with some edits. I will not link the post from the other forum as I am a new poster on the EA forum and I don’t want to be flagged for spamming. You will have to assume the dates are cherry picked. ================================================================= From Dec 2015 to Dec 2018, fed increased int from 0-.25 to 2.25-2.5 (a 10x increase!) and [55% S&P 500 and 45% long term treasuries] [nearly matched 100% S&P 500]. Edit: [A 55% S&P 500 and 45% inverse long term treasuries does worse]: https://www.portfoliovisualizer.com/bac … tion2_1=45
From Jun 2004 to Jun 2006, fed increased from 1.25% to 5.25% and [55% S&P 500 and 45% long term treasuries] also [nearly matched 100% S&P 500]. Edit: [A 55% S&P 500 and 45% inverse long term treasuries does worse]: https://www.portfoliovisualizer.com/bac … n10_1=-200 =================================================================
3) Finally, I must express my appreciation for the valuable insights presented in this piece. The authors’ diligent research and thoughtful analysis truly made an impact on my perspective. I am now more wary of assets that are sensitive to interest rates than the average investor.
Levered ETFs exhibit path dependency, or “volatility drag”, because they reset their leverage daily, which means you can’t calculate the return without knowing what the interest rate does in between the 3% rise
The entire section is based on a first-order approximation, as explicitly noted in the post (which is also why we set aside e.g. the important issue of convexity). This point is of course correct!
A related point: The US stock market has averaged 10% annual returns over a century. If your style of reasoning worked, we should instead buy a 3x levered S&P 500 ETF, get 30% return per year, compounding to 1278% return over a decade, handily beating out 162%.
This calculation, like that of many other commenters, estimates the total return. What matters is risk-adjusted return (a la Sharpe ratio). If you think the market is literally wrong with certainty, then the bet could be literally risk-free (“infinite Sharpe”, speaking loosely). If you aren’t 100% certain, then you have a finite risk-adjusted return, but still high—how high depends on your confidence level (etc).
Equities, on the other hand, have risk!
We welcome other criticisms to discuss, but comments like your first line are not helpful!
The point of my comment was that even if you’re 100% sure about the eventual interest rate move (which of course nobody can be), you still have major risk from path dependency (as shown by the concrete example). You haven’t even given a back-of-the-envelope calculation for the risk-adjusted return, and the “first-order approximation” you did give (which both uses leverage and ignores all risk) may be arbitrarily misleading, even for the purpose of “gives an idea of how large the possibilities are”. (Because if you apply enough leverage and ignore risk, there’s no limit to how large the possibilities are of any given trade.)
We welcome other criticisms to discuss, but comments like your first line are not helpful!
I thought about not writing that sentence, but figured that other readers can benefit from knowing my overall evaluation of the post (especially given that many others have upvoted it and/or written comments indicating overall approval). Would be interested to know if you still think I should not have said it, or should have said it in a different way.
I think this post contains many errors/issues (especially for a post with >300 karma). Many have been pointed out by others, but I think at least several still remain unmentioned. I only have time/motivation to point out one (chosen for being relatively easy to show concisely):
Levered ETFs exhibit path dependency, or “volatility drag”, because they reset their leverage daily, which means you can’t calculate the return without knowing what the interest rate does in between the 3% rise. TTT’s website acknowledges this with a very prominent disclaimer:
You can also compare 1 and 2 and note that from Jan 1, 2019 to Jan 1, 2023, the 20-year treasury rate went up ~1%, but TTT is down ~20% instead of up (ETA: and has paid negligible dividends).
A related point: The US stock market has averaged 10% annual returns over a century. If your style of reasoning worked, we should instead buy a 3x levered S&P 500 ETF, get 30% return per year, compounding to 1278% return over a decade, handily beating out 162%.
1)
For what it’s worth, volatility decay will tend to enhance returns in a bull market for the same reason it exacerbates losses in a bear or sideways market.
This means in a rising rates scenario I would actually expect an inverse leveraged ETF to do better than a margin account that shorts treasuries with the same leverage. This actually just happened in 2022.
In 2022, TLT the 1x long term treasuries ETF lost 31%, TMF the 3x long term treasuries ETF lost ‘only’ 73%, while TTT the 3x short long term treasuries ETF gained 150%.
TLT – Performance – iShares 20+ Year Treasury Bond ETF | Morningstar
TMF – Performance – Direxion Daily 20+ Yr Trsy Bull 3X ETF | Morningstar
TTT – Portfolio – ProShares UltraPro Short 20+ Year Trs | Morningstar
This is a counterexample to the numbers Wei Dai posted, to show that volatility decay is not necessarily always harmful.
That said...
1) The article recommends financial instruments that are extremely volatile, as the percentage gains and losses I posted above indicate.
2) Long term treasuries have ~5% gains/year historically, so shorting long term treasuries under normal circumstances means you will keep losing 5% every year (or 15% if you are 3x).
As I said earlier, volatility decay on its own is not the worst thing in the world if you have positive expected returns. But if you combine volatility decay with extremely high volatility and historical negative returns, I do believe that would make it a risky combination. I ultimately agree with Wei_Dai.
2)
2022 and the 1970s showed that inflation or nominal GDP growth can wreak havoc on asset values.
The discussion here is on real rates though, not nominal rates. Do we examples of rates rising in a low inflation environment? Yes! I came across a couple while browsing another forum a while ago. I will copy the relevant post below with some edits. I will not link the post from the other forum as I am a new poster on the EA forum and I don’t want to be flagged for spamming. You will have to assume the dates are cherry picked.
=================================================================
From Dec 2015 to Dec 2018, fed increased int from 0-.25 to 2.25-2.5 (a 10x increase!) and [55% S&P 500 and 45% long term treasuries] [nearly matched 100% S&P 500]. Edit: [A 55% S&P 500 and 45% inverse long term treasuries does worse]:
https://www.portfoliovisualizer.com/bac … tion2_1=45
From Jun 2004 to Jun 2006, fed increased from 1.25% to 5.25% and [55% S&P 500 and 45% long term treasuries] also [nearly matched 100% S&P 500]. Edit: [A 55% S&P 500 and 45% inverse long term treasuries does worse]:
https://www.portfoliovisualizer.com/bac … n10_1=-200
=================================================================
3)
Finally, I must express my appreciation for the valuable insights presented in this piece. The authors’ diligent research and thoughtful analysis truly made an impact on my perspective. I am now more wary of assets that are sensitive to interest rates than the average investor.
The entire section is based on a first-order approximation, as explicitly noted in the post (which is also why we set aside e.g. the important issue of convexity). This point is of course correct!
This calculation, like that of many other commenters, estimates the total return. What matters is risk-adjusted return (a la Sharpe ratio). If you think the market is literally wrong with certainty, then the bet could be literally risk-free (“infinite Sharpe”, speaking loosely). If you aren’t 100% certain, then you have a finite risk-adjusted return, but still high—how high depends on your confidence level (etc).
Equities, on the other hand, have risk!
We welcome other criticisms to discuss, but comments like your first line are not helpful!
The point of my comment was that even if you’re 100% sure about the eventual interest rate move (which of course nobody can be), you still have major risk from path dependency (as shown by the concrete example). You haven’t even given a back-of-the-envelope calculation for the risk-adjusted return, and the “first-order approximation” you did give (which both uses leverage and ignores all risk) may be arbitrarily misleading, even for the purpose of “gives an idea of how large the possibilities are”. (Because if you apply enough leverage and ignore risk, there’s no limit to how large the possibilities are of any given trade.)
I thought about not writing that sentence, but figured that other readers can benefit from knowing my overall evaluation of the post (especially given that many others have upvoted it and/or written comments indicating overall approval). Would be interested to know if you still think I should not have said it, or should have said it in a different way.