The Time and Place

Much has been written to vilify levered ETFs. In fact, many blame them for the equity market volatility of recent years, specifically the flash crash of May 2010. I find this generalization frustrating. After all, it is just about math.

Leveraged ETFs may not track the index exactly over the medium to long-term. They may even be downward-sloping, meaning they are more likely to go down rather then up due to the effect of daily rebalancing. But, again, it is just math. The daily rebalancing impacts the long-term return and if the market is not trending it has a negative impact on price performance in comparison to the corresponding benchmark. That said, leveraged ETFs have a definite time and place and the best use is to capture short-term moves. With reduced capital requirements, an investor can hedge an entire portfolio without having to sell or raise cash. Or, if an investor is expecting a short-term move (up or down), and wants to take advantage of the short-term volatility it can be done with limited stress on the funding levels. Whether you are a hedger or an outright speculator, there is a benefit to be had from a product like this.

This is all a long lead-in to a recent phenomenon I have noticed in the major indices that have been occurring on the first day of the month. An abnormally high percentage of each month’s return, in the S&P 500 for example, has occurred on the first day of the month. Since the bottom was reached in the S&P 500 in March 2009, we have had 23 first days of the month. Of those 23 periods, the first day of the month has been the same direction as the rest of the month 17 times, or 73.9% of the time. The average return of each month since then (4/1/2009) is 2.35%. The average return of the first day of these months is 0.8%, or 34%. If we look at these numbers since January 1, 2010, these figures become more significant even. In the 14 measurable periods since then, the average monthly return for each month has been 1.35%. The average return for the first day of each month has been 1.05%, a staggering 76%.

There is an additional, equally alluring component to the “first of the month” phenomenon of late. Since April 1, 2009, 82.6% of the “first days” (23 total) have been positive, averaging 1.33%. Of the four days that were negative, the average return is -1.71%. The average return for all days in this sample was 0.81%, with the best day at 2.95% and the worst at -2.58%. A more recent view of this trend paints a similar, more compelling picture. Since January 1, 2010, 12 first days of the month have seen the S&P 500 rally, with only two showing a decline. The average return on positive days has been 1.4%, with a -1.02% on the two down days. The best day in this sample is 2.95% still, with the worst day at -1.72%.

I believe this pattern is due to two things; bullish consensus with low conviction, thus creating a chasing effect on the first day of the month as frustrated investors that missed yet another positive month just buy everything as the new month gets under way, and simply a bull market trend. Bringing this exercise full circle, whatever the reason for this might be if this pattern continues into March this is the perfect use of levered ETFs to capture this pattern. Investors can buy highly levered ETFs like UPRO and SQQQ which give triple leverage to the long side of the S&P 500 and NASDAQ 100, respectively. Since this trade is trying to capture the movement of a single day this is the perfect scenario for these products. While I am not suggesting this pattern should continue to work, and of course past performance is not indicative of future results, if you wanted to “go for it” this is a time and place for levered ETFs. In the spirit of full disclosure, my logical mind would not typically invest much capital on a pattern that I can’t explain. It is hard to ignore what I would dismiss a statistic of this significance to mere coincidence,

More interesting is you can sit out the rest of the month which will clearly reduce the risk/return profile as the lowest risk position is out. So with month end around the corner and the first day’s pop to follow you might want to keep your powder dry.