Why not use leveraged exchange-traded funds (ETFs) in the Couch Potato Portfolio or in a similar passively indexed portfolio such as the One-Minute Portfolio? Couldn’t we boost returns dramatically?

An example of a leveraged ETF is the Horizon BetaPro S&P/TSX 60 Bull Plus (T: HXU), which returns twice the change in the S&P/TSX 60 Index. Let’s put it in the Classic version of the Couch Potato Portfolio to represent the 33.3% allocation to Canadian stocks.

Let’s also add a leveraged U.S. equity ETF for the 33.3% allocation to U.S. stocks and a leveraged ETF bond fund for the 33.3% allocation to bonds. What happens to the portfolio’s average annual return of 11%?

If historical trends hold up (and adjusting for fund fees), the average annual return will be approximately 20% over the long run. That’d be great, wouldn’t it? And all for 15 minutes work a year without the help or fees of a financial advisor.

An average return above 20% could turn some investing rules on their heads. Like the one about paying off mortgage and car debt before starting to invest (always pay off credit-card debt first). You would be further ahead plowing savings into the Couch Potato Portfolio or other passively indexed portfolio.

Alas, there are a few flies in the ointment. One is the fact that leveraged ETFs promise only twice the daily index return, not twice the index return over a week, month, year, or longer period. The difference in returns can be significant. For a simplified example of why this is so, see page 51 of the Horizon BetaPro prospectus.

A second is the typically high annual management fee charged by leveraged funds (1.15% for HXU). A third is the transaction costs of the daily rebalancing of the underlying basket of index futures, swaps, options and other derivatives to maintain a constant leverage factor of two. A fourth is the interest paid to buy and hold derivatives on margin.

The second to fourth factors are obviously drags on the performance of the ETF. The first factor, daily rebalancing, can augment or dampen performance depending on how the stock market moves.

If the market rises in smooth fashion, daily rebalancing adds to returns. That’s because more index futures, swaps, etc., have to be bought each day to maintain the constant leverage factor of two. This increases the principle invested and the compounding effect.

There is even a chance, in steadily rising markets, that the compounding effect could overcome the three cost factors and deliver close to twice the index increase over long-term periods. But the same cannot be said for other kinds of markets.

If the market is volatile, rebalancing can add to the drag of the three cost factors and may even pull the leveraged ETF fund down below the unleveraged ETF. The latter result has actually occurred. As Tristan Yates observes in his soon to be released book, Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance:

“On June 21st, 2006, the Ultra S&P 500 ProShares ETF began trading at a dividend-adjusted price of $64.90. … On April 1, 2008, this security closed at a dividend-adjusted price of $70.55. This represents a total return of 8.7 percent for the just over twenty-one month period, and an annualized return of 4.8 percent. In contrast, the [unleveraged] SPY ETF rose from $121.61 to $136.61 in the same period, a 12.3 percent total return for the 21 months and a 6.7 percent annualized return.”