Lambda: Investing in leveraged ETFs using algorithms

AlphaInvestors reminds you that levered ETFs are generally riskier than ETFs without leverage or inverse exposure.

Lambda – the algorithm, utilizes computers to collect and analyze data from the financial markets seeking levered ETFs and recommends ones to own based on their relative ranking.

Lambda– the subscription, provides quantitative analysis to individual investors with algorithm-based ETF selection and buy/sell guidance.

Lambda is designed for sophisticated investors seeking maximum growth throughout all market conditions –

Levered ETFs– constructed from derivatives, magnify the daily returns of the underlying index
Bull and Bear ETFs– allow sophisticated investors to seek growth in up and down markets
Increased volatility– levered ETFs expect daily returns magnified 2× or 3× that of the underlying index
Increased frequency– investors should be prepared to exit trades quickly to avoid losses
Brokerage account– investors must have a brokerage account approved for trading ETFs
Subscription– to lambda provides weekly updates

Levered and Inverse ETFs

During the previous century, investors could only obtain leverage through using margin or options. Levered ETFs now allow investors to obtain leverage without buying on margin or the risk of infinite losses.

Margin –borrowing money from their broker to buy or short securities. Unfortunately, investors could be required to sell their investments if the market trended counter to their position and were also forced to pay interest monthly.
Inverse –shorting involved borrowing a security from their broker (paying interest monthly) to sell with the hopes of buying it back later at a lower cost. Shorting losses can be unlimited!
Options –allow investors to control blocks of stocks for a period of time. When the time period expires investors are able to realize a profit or complete loss of invested capital.
Levered ETFs –allow investors to obtain leverage (bull or bear) buy simply buying an ETF with risks limited to loss of their invested capital.

Algorithm Investing with Lambda

The example presented in this blog post assumes an investor has decided to allocate $4,000 to the Lambda quantitative investment strategy. Lambda selects up to two (2) ETFs, depending on market conditions, that meet strict criteria:

Historical – Have existed through both up and down markets
Scale – Have more than TBD Assets Under Management
Liquidity – Trade more than TBD shares per day
Focused – Be concentrated in a sector or geographic region
Passive – Tracks a declared index that does not change objectives over time
Diversification – Avoid similar or overlapping sectors (i.e. Lambda will not select two similar or overlapping sector ETFs offered by competing issuers)

Investors should allocate their capital equally among two (2) ETFs. Over a decade of statistical analysis has shown that equal allocation among two ETFs results in the maximum investment return.

allocating assets for Alpha Lambda algorithms — Figure-1: How an investor could allocate their investment capital among Lambda and Alpha algorithms. In this example, the investor would allocate $4,000 or 20% of their algorithm dedicated assets equally between the two ETFs recommended by Lambda.

Making an Investment using Lambda

Investors should allocate equal amounts of their investment capital into two (2) equal allotments. In the example presented, the investor allocated $4,000 to the two (2) ETFs recommended by Lamba.

Example Investment

An investor would purchase integer number shares of each fund closest to the allotment divided by the price per share. This example results in a residual cash balance of $139.50, along with their two ETFs.

Lambda asset allocation example — Figure-2: This option demonstrates how an investor would allocate their $4,000 working capital among the two (2) ETFs recommended by Lambda. Investors are left with a cash residual in their accounts. Commissions, charged by many brokerages, would leave investors with a smaller cash residual than shown in the example.

Your Weekly Subscription

Each weekend Lambda subscribers will be presented with the weekly update graphic showing the current portfolio’s holdings (ETF ticker symbols or cash), the recommended action for the following week (Buy – Hold – Sell), and the allocation to each ETF, Figure-3.

Lambda weekly Buy Hold Sell ETF — Figure-3: Each week, investors are encouraged to log into their Lambda subscription at alpha-vest.com. The graphic shows the current portfolio’s holdings (ETF ticker symbols or cash), the recommended action for the following week (Buy – Hold – Sell), and the allocation to each ETF.

Once an ETF gets sold, it becomes a cash ($) position until the ETF is either bought again or gets replaced with different ETF.

Periodic Rebalancing

Periodically some or even both positions will be replaced with different ETFs. The process is called a re-balance. During a re-balance, investors will re-allocate 50% of their Lambda capital to each of the two (2) new ETFs.

Trends

During periods of high volatility, trends can become difficult to discern. Levered ETFs typically re-balance their holdings at the end of each trading day (buying or selling swaps and futures). Levered ETFs attempt to magnify the returns of their underlying index on a daily basis which may not track as closely over long periods of time. As a result, levered ETFs can accrue losses during periods of high volatility or non-trends. Lambda continuously monitors levered ETF trends with the objective of:

Up-trends – Lambda is likely to recommend levered bull ETFs
Down-trends – Lambda is likely to recommend levered bear ETFs
Non-trends – Lambda is likely to recommend holding cash

Lambda is only intended for sophisticated investors who understand the risks involved with leverage and take an active interest in monitoring their investments weekly if not daily.

Allocation

Investors are encouraged to maintain a consistent allocation across their entire portfolio. Although levered returns may significantly outpace other positions in an investor’s portfolio, it is strongly encouraged to maintain a fixed allocation. Levered allocations may experience significant losses during transitional periods.

Points to Consider

Lambda is a mathematical model. It purchases and sells ETFs at the close on Fridays. It is 100% invested (i.e. it can purchase and sell fractional shares). Lambda does not pay commissions or taxes. Investors may end up buying and selling for slightly more or less the following week, can only purchase integer number of shares, and may be required to pay brokerage commissions, resulting in slightly different investment returns than Lambda.

Brokerages can and do charge clients commissions for buying and selling securities. Investors may need to allow for a small cash residual to cover the commission expense when purchasing ETFs. Commissions will automatically be deducted from the proceeds of sales.

Additional Information

AlphaInvestors highly recommends learning about levered ETFs prior to investing:

Geared Investing: An introduction to leveraged and inverse funds by ProShares

Understanding Leveraged Exchange Traded Funds: An exploration of the risks & benefits by Direxion