Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez. Thank you, Mary, and welcome to Risk Parity Radio.

Mostly Uncle Frank [0:44]

If you are new here and wonder what we are talking about, you may wish to go back and listen to some of the first episodes where we did our introductions of the various topics. And those episodes are episode one, three, five, seven and nine. And so if you go back and listen to those, it will get you up to speed. But now onward to episode 152. Today on Risk Parity Radio, we're going to give Mary a break from the onslaught of emails that continues. Mary, Mary, why you buggin'? And what we're gonna do today is do an analysis of an ETF, UPRO, requested by one of our listeners, Anderson, and is long overdue.

Mostly Voices [1:32]

He was holed up in his office for an hour before the show and this is sort of what happened.

Mostly Uncle Frank [1:40]

Yes! And to do this we will use J. David Stein's 10 Questions to Master Successful Investing. And so without further ado, Question 1：what is it? It is an exchange-traded fund called ProShares UltraPro S&P 500. And I'll read to you from the fact sheet：ProShares UltraPro S&P 500 seeks daily investment results before fees and expenses that correspond to 3 times 3x the daily performance of the S&P 500. So it is a leveraged fund designed to mimic three times the performance of the S&P 500 on any given day. And we'll get more into the guts of how it does that as we go forward with these questions. So question two, is it an investment, a speculation, or a gamble? Well, it is based on the S&P 500, so we would characterize it as an investment. Part of what the fund holds, a large part of what it holds, is in fact the 500 stocks in the S&P 500 in a cap-weighted fashion. So it matches up with the index on that. What it's got overlaid on top of it then to create the leverage is largely swaps contracts. And what are these swaps contracts? I'll read to you from the summary prospectus, which I'm also going to link to in the show notes along with the fact sheet. And it says, swap agreements. Contracts entered into primarily with major global financial institutions for a specified period ranging from a day to more than one year. In a standard swap transaction, two parties agree to exchange the return or differentials in rates of return earned or realized on particular predetermined investments or instruments. The gross return to be exchanged or swapped between the parties is calculated with respect to a notional amount, e.g. the return on or change in value of a particular dollars invested in a basket of securities or an ETF representing a particular index. Now, what does that mean? You have a gambling problem.

Mostly Voices [3:54]

Broken down, essentially this is a bet.

Mostly Uncle Frank [3:59]

And one side of the bet is that the S&P 500 is going up. And if that happens, then the other party has to pay the person that's betting on it going up. But if the reverse happens, if it goes down a particular day, then the party betting on it going up has to pay the other party who's betting on the other side of it going down. All right, who are these parties on the other side of the swap agreements in this case? For UPRO, they are very large financial institutions that you will probably be familiar with. They include Bank of America, Bnp Paribas, Citibank, Credit Suisse, Goldman Sachs, JP Morgan, Society Generale, and UBS. So basically most of the world's largest financial institutions. And so when the S&P 500 goes up in value, those institutions must pay on the swap contract into the fund and vice versa. What does that mean for our question two? Is it an investment, a speculation, or a gamble? You would have to say that UPRO is an investment with a speculative component to it, because part of the fund is just invested straight in the S&P 500, holds the shares of those companies. Then another part of the fund is invested in these swap contracts, which are speculating on the behavior of the S&P 500 itself. This fund also holds some futures contracts, but they are not a very large component of what is going on inside this fund. So the answer to question two is that it's an investment with a speculative component. All right, question three. What is the upside? Well, when the stock market is going up, this fund tends to go up and go up a lot more. So just looking at the fact sheet, For the fourth quarter of 2021, the S&P 500 was up 11%. This fund was up 34.22%. So a little more than three times in that circumstance. In the entirety of last year, 2021, the S&P 500 was up 28.71%. This fund was up 98.64%. So actually greater than three times the performance of the S&P 500. Over five years, the comparison is S&P 500 up 18.46%. This fund was up 41.51% over 10 years, 16.54% for the S&P, 41.03% for the UPRO fund. And since inception, which was in 2009, the S&P was up 16.59% annualized. This fund is up 40.47% annualized since inception. So it's up a lot. Yeah, baby, yeah! you! can see, however, that this fund over time does not match exactly three times the S&P 500. Over short periods of time, it can exceed it like what happened last year. Over long periods of time, it tends to lag a bit. Part of that has to do with the fees, which we'll get into the next question. But basically, when the stock market is going up, this thing is going to perform like gangbusters. and that is the upside of it. All right, question four, what is the downside? Well, the downside is when the stock market is performing poorly, this fund will also perform poorly and three times as bad as the stock market on a day-to-day basis. So that's one downside. Another downside is this fund is designed around a single day performance. It's designed to be a trading vehicle mostly. So over time, its performance viS-A-Vis the S&P 500 may vary substantially from three times. Sometimes it can be more than three times, like last year. Over time, it tends to be less than three times. Part of that has to do with its fee structure. It has a relatively high expense ratio of 0.91%, and over time that will detract from its performance. Now, what are the other downsides? Well, the summary perspective lists a whole bunch of risks, which are typical in these prospectuses, but just going over a few of them. One of them are the risks associated with the use of derivatives. These risks include counterparty risk, liquidity risk, and increased correlation risk. When the fund uses derivatives, there may be imperfect correlation between the value of the referenced assets underlying the the derivative here, the S P 500 Index and the derivative, which may prevent the fund from achieving its investment objective. So what they're saying is it may not perform like they want it to with this 3X times the S P 500. In fact, it has over its history. We can say that, but that doesn't mean that that will necessarily hold in the future. Now, that counterparty risk is important also to think about. That has to do with whether those parties on the other side of these swap agreements, namely those large financial institutions, can pay when they're supposed to pay. That's a counterparty risk. Now, you'd have to say, given the quality of those institutions, the chances that they can't make good on their promises are probably pretty low, but nevertheless, it is a risk. And anytime you're dealing with a contract, you have a counterparty risk to think about.

Mostly Voices [9:27]

You need somebody watching your back at all times.

Mostly Uncle Frank [9:31]

The other risks listed here are leverage risk, compounding risk, correlation risk, rebalancing risk, equity and market risk, concentration on focused investing, exposure to large cap companies, non-diversification, index performance, the index itself, intraday price performance risk, that it might not do what you want on a particular day, Market price variance risk and liquidity risk, portfolio turnover risk, tax risk, valuation risk. I will link to this in the show notes so you can read all these things. But a lot of these are also inherent in any index fund. So don't think that this is unusual. What is unusual for this fund has to do with the leverage and the swap contracts, because otherwise it would just be like a regular S P 500 fund. But all of those risks could create potential downsides in addition to just the fact that if the S P 500 goes down, this fund is likely to go down three times as fast. All right, question five. Who is on the other side of the trade? Well, this is an ETF that is widely traded and traded a lot on a daily basis because it's also used by speculators to get in and out of the market for short periods of time. So you're dealing with a lot of speculators, but that also creates a lot of liquidity. So it's very easy for an individual investor to buy and sell this fund without facing large bid ask spreads or problems of getting in and out of it. The other parties on the other side of the overall idea of this are obviously those parties holding the swap contracts. on the other side, those financial institutions that I mentioned before. I should also note that UPRO is part of a kind of suite of leveraged products that trade on various parts of the stock market, part of the ProShares suite of ETFs. And they have ones that are bearish on the stock market, ones that are bullish on the stock market. They have one that specializes in the NASDAQ, for instance. And then there's another suite of these run by Direction Shares that are similar in nature. So this is kind of part of an overall ecosystem of these leveraged funds, if you will. All right, question six. What is the investment vehicle? Well, it's an exchange traded fund, a very efficient way of organizing these things. And they have done a good job with this fund creating it and given how it's performed since its inception. in 2009, it has performed as advertised since then, but it is the basic ETF structure. All right, question seven. What does it take to be successful? Well, not a whole lot of thought. If you think the stock market is going up and you buy this thing, you're probably going to be successful as holders of it have been for the past decade or so. It does not require any other particular skills to invest in. given that it's simply based on the S&P 500. All right, question eight, who is getting a cut? Well, largely pro shares is getting a cut. They're getting their 0.91 expense fee, which is a pretty high fee. It's not that high for a product like this that has swap contracts in it and those sorts of things, but it is high when you compare it to run-of-the-mill index funds. There are also tax considerations that you need to be aware of when investing in something like this. Particularly if you were to jump in and out of it, you could have lots of different tax liabilities that may or may not offset. But other than that, for us mostly buy and hold investors, it's taxed like any other fund. If you hold it for a year, you'll get that long-term capital gains tax rate on it. And if you don't, it'll be ordinary income, either positive or negative as the case may be. All right, question nine, how does it impact your portfolio? Well, it's going to magnify the effects of investing in the stock market when you put this in any portfolio. So it's going to create a lot more volatility, potentially a lot more reward, but along with that comes some risk. This is an interesting product for risk parity style portfolios because if you recall the history of risk parity investing when it was first developed back in the 1990s, The problem with a basic risk parity style portfolio that seeks to balance out risks is it tends to end up with a very conservative looking portfolio, something that looks like that sample portfolio, the all seasons portfolio. That's too conservative to be useful for most people in most circumstances. So the solution for hedge funds then was to add leverage, usually in the form of borrowing in those circumstances or the actual use of futures and options contracts to add leverage to a very conservative portfolio to make it perform with the kind of risks you would associate with a 100% equity index portfolio. The idea was that you can increase the risk, but you're also going to increase the reward. And since the portfolio is efficient or more efficient than 100% index portfolio, it's going to perform better over time. Now, funds like this were not designed for long-term holdings, but in fact, people have been able to use them that way, at least in the past decade. And so this is a very convenient way for a individual investor to add some leverage to a portfolio because it doesn't require taking out of loans, it doesn't require managing options or futures contracts. It's a very simple product to be able to buy to get leverage into the portfolio. And so people have taken old conservative portfolios and then used this to leverage that kind of portfolio up. You see a lot of this at the optimized portfolios website. And the guy who runs that kind of specializes in taking, say, like a Bogleheads three fund or a permanent portfolio. adding leverage to it with these leveraged funds and then seeing how it works. I will give you a couple of links to that in the show notes, but he does a very good job in exploring all the ways you might use these kind of funds in a portfolio to essentially create a levered up version of very conservative portfolios. And so we have also created a couple variations on this theme in our sample portfolios, the experimental portfolios that we have using these leveraged funds. One of them is the Accelerated Permanent Portfolio, and that's based on Harry Brown's original Permanent Portfolio, which was just 25% in an index fund. And so instead in that portfolio, we have 25% in UPRO, which gives you the leverage, making it more like 75%. We've also taken this and we created what we call the aggressive 50/50 portfolio, which is just the idea of what if you had a 50% stock, 50% bond portfolio and you added some leverage to it. And so we've done that by using UPRO and a leveraged bond fund, TMF. Now the question always becomes, well, how much of this do you want to use? Because how much leverage do you want to create? Because the more leverage you put into something like this, the more volatile it's going to be. So some people have created portfolios that are all leveraged funds, like the Hedge Fundies Adventure Portfolio is all UPRO and TMF. It ends up being a pretty bumpy ride, so you're probably better off scaling back on how much of one of these things you would actually want to use, but you can easily take a portfolio that would be 100% and add another 100% in leverage just by adding one of these funds. And so we're also, this might be useful and we've used it in our Risk Parity Ultimate portfolio is if you just want to add a little bit of leverage. So in that portfolio we have 5% in this fund, UPRO. So it essentially adds 10% in leverage to the portfolio. and why would you want to do that? You'd want to do that if you have other things in your portfolio that are going to drag the portfolio down. In that portfolio in particular, there is a volatility fund, VIXY, which you would think in most years is going to lose money. To cover that, you can add some leverage on the stock side of it to balance those things out. that was weird, wild stuff. I did not know that. And that is an example of how you can just use a small amount of this for a particular purpose and that you don't have to go overboard like we have in the experimental portfolios. But you could see a lot more variations on this theme at that optimized portfolios website. He has a whole section on levered portfolios, and I'll link to that in the show notes so you can Take a look at all kinds of different variations of what he's got going on there. All right, question 10. Should you invest? I would say for most people the answer is probably no, or at least it should be of limited exposure to this thing. And why is that? The real reason is it just hasn't been around that long. It's been around since 2009, which has been a very good era for investing in the stock market. So you'd expect something like this to do well. It's unclear how it would actually perform, say, from the decade of 1999 to 2008. So there may be some inherent risks that we really haven't discovered, even though they're described as best they can in the prospectus. But on the other hand, if your goal is to add leverage to a portfolio that you might have done through taking margin say, in a margin account. This may be an alternative way of doing that, and it may be appropriate for somebody who's got part of their holdings that they are not worried about needing or blowing up. Or I have used this is in a Roth IRA that I don't intend to ever use, but I'd like to see if I can grow it a lot for my heirs, and you can avoid the tax consequences in a place like that. But if you were also trying to create some kind of aggressive strategy, maybe you're very young and you just want to take a little part of your assets and do something like this with it, this would be a useful tool for that sort of thing. Just be aware of the risks. Well, you have a gambling problem. Overall, I would say a little leverage may be helpful in certain circumstances, but a lot of leverage can be a very Dangerous thing. You can't handle the gambling problem. That doesn't mean we should run away screaming in terror.

Mostly Voices [20:59]

We got a scary one for you this week.

Mostly Uncle Frank [21:03]

But it does mean we should be careful and not bet the farm on something like this. I'll show them. I'll show them all. So if you do choose to use something like this, please do read the prospectus, read the fact sheet, go to the Optimized Portfolios website, look at all the things that they've done with it, what has worked well and what hasn't, and just be careful out there.

Mostly Voices [21:30]

Yes, cat, now I shall be ruler of the world. But now I see our signal is beginning to fade.

Mostly Uncle Frank [21:38]

We'll pick up this weekend with our weekly portfolio reviews of the seven sample portfolios you can find at www.riskparityradio.com and we'll also get back to looking at some emails. If you have comments or questions for me, please send them to frank@riskparityradio.com that email is frank@riskparityradio.com Or you can go to the website www.riskparityradio.com and put your message in the contact form there and I'll get it that way. If you haven't had a chance to do it, please go like, subscribe, give me some stars and a review at your favorite podcast provider. That would be great. Mmmkay? Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Voices [22:30]

No one can stop me. I want money and power and money and power and money and power. The Risk Parity Radio Show is hosted by Frank Vasquez.

Mostly Mary [22:47]

The content provided is for entertainment and informational purposes only and does not constitute financial investment, tax or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.