May 06, 2010
One of the major benefits of exchange traded funds is that they provide greater precision in allocating risk. ETFreplay.com has intentionally built virtually every one of our website pages with risk/volatility in mind. When we designed the layout, we felt that volatility should not be an indicator in the lower pane of a charting layout – it is too important – so we created an ETF Charts layout that deliberately puts the 2 main components of the Sharpe Ratio in the upper pane. We do this because for sophisticated investors: discussing returns without the context of risk is meaningless.
One interesting way to appreciate the Sharpe Ratio is to show how it cannot be fooled by something like the ProShares leveraged index ETFs. This is a useful exercise as the nature of compounded returns is actually quite a bit more complex than it seems.
SSO is the 2x leveraged long S&P 500 ETF. By construction, it will always have 2x the volatility as the S&P 500 --- but as you look past the short-run, only in the very best case scenario will it equal 2x the daily mean return of the S&P 500.
It is possible that leveraged ETFs can have roughly equal Sharpe ratios vs the unlevered ETF --- but never more --- and very often much worse. The compounding of returns over time is the killer -- only in the case of a non-stop upward move will the sharpe ratio be approximately equal. The nature of compounding is that large losses are disproportionately hard to make up in a rally while outperformance can be quite easy to give up in a correction if you are not careful on watching volatility.
From an investors perspective – the leveraged products are flawed. We will spare the reader the math on this and instead show the very dramatic leveraged ETF charts as a more extreme example of how important it is to avoid high volatility ETF’s when they do not have relative strength – the losses are just too great. The converse of this is that by focusing on the Sharpe Ratio for your portfolio (intentionally reducing volatility when there is no relative strength), you stand at a distinct advantage of benefitting from the likely long-term outcome of markets that don’t just forever run up in non-stop fashion:
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