Risk Parity Basics: Intro to Capital Efficient ETFs

These are certainly exciting times to be an individual investor! One revelation lately has been the new wave of blended Capital Efficient ETFs, but after mentioning that term to a friend, I realized they haven’t gotten the publicity they deserve. So, here’s a RP Basics post to shed some light.

Was talking to a friend about portfolio construction, and had a moment where I remembered that the things I get excited about are not necessarily universal. To wit, capital efficient ETFs, one of the most exciting new tools to come along for investors since expense ratios below .1%. I start mentioning this, mentioning that, and got fully geeked up.

“Um, what are Capital Efficient ETFs?” he asked.

Er, record scratch…

Sounds like a Risk Parity Basics post is in order, so here you go, MB: all about Capital Efficient ETFs!

I have covered capital efficiency before, in this blog post where I tested different versions of such a portfolio compared to a traditional 60/40.

Testing Three Variations of a Leveraged 60/40
Heard on a podcast once that any idiot can run a portfolio backtest, but beware of their conclusions. Ladies and gentlemen, I resemble that remark, so here I am fiddling with a few leveraged 60/40s. No recommendations here, just testing some variations on a theme!

Read that one if you want a preview about how they work in practice, but with this post, I’m taking a step back, and delving more into what capital efficiency is in general. I’ll do this one as a “Risk Parity Basics” post, meaning I’ll start from the ground up with minimal use of jargon, just hoping to provide necessary context for later.

In the second post, I’ll zero in on two such funds, GDE and NTSX (more on them below), and do a simple illustration of how they perform in a portfolio. If I find a good article or academic paper about capital efficiency ETFs, I’ll probably make that a third post.

So, What Are Capital Efficient ETFs?

These are funds that enable investors to put up less actual capital to get a certain level of exposure to a given market. They do this by using modest amounts of leverage and investing via the futures markets (see below) rather than just buying the assets on the investor’s behalf. The strategy is nothing new, but new products with reasonable expense ratios have come on line in the past few years, suddenly making these much more accessible to DIY investors (hip hip hooray!).

WisdomTree is the leading ETF provider for this strategy, and currently have five such ETFs in their roster. I’ll be focusing on two of them in this series: 1) NTSX, the WisdomTree US Efficient Core Fund, and 2) GDE, the WisdomTree Efficient Gold Plus Equity Strategy Fund. The WisdomTree funds blend different asset classes, using a “buy and hold” strategy for equities, and then futures to gain exposure to fixed income or gold.

There are also capital efficient ETFs that are not blended; they use the same basic strategy but concentrate on just one asset class. UPRO from ProShares, for example, targets three times the performance (on a daily basis) of the S&P 500 index, and TMF from Direxion does the same to track a 20-year Treasury Bond Index.

These are capital efficient funds, as well, but with their heightened use of leverage, they are sometimes better known as “embedded leverage ETFs.” I’ll focus on these some other time, but at the root level, this post on the blended versions like NTSX will help you understand the concentrated versions like UPRO.

Brief Detour About Futures

To understand capital efficient ETFs, a solid grasp on futures and how leverage is used to gain more exposure to an asset class are crucial first steps. If you’re already comfortable with these topics, then skip a few sections down to “Putting the Pieces Together.” 

Didn’t skip? Then let’s start here: A futures contract is a legal agreement to buy or sell an asset at a certain price at a specified time in the future. A buyer of a futures contract pays a small fee to initiate the contract, and also needs to put up the money to fulfill the contract, but crucially, doesn’t actually hand the money over until the future purchase date.

To give an example: say it is February 5th, and the price of copper is $100 per unit (call this the “spot price”). I can buy a three-month futures contract, coming due on May 5th for one unit of copper at the specified price of $102. I will pay $1 as a transaction fee to initiate the contract, and must also have proof that I have access to $102 to complete the purchase when May rolls around.

Fast forward to May 5th. If the “spot price” at that time is above $103 (my contract price plus the $1 for the fee), then I can make money. If it is below $103, I will have lost money. Either way, my purchase will go through, and I will gain ownership of one unit of copper.

But, and this is pretty cool, I don’t actually need to take possession of the unit of copper if I don’t want to. I can sell the contract to someone who does actually want it, mainly the people in industries that are actually buying and using copper. By buying a never ending stream of futures contracts for different lengths, all maturing at different times, I can track the price of copper without ever actually owning it.

Behind the Scenes with Leverage

The futures market also allows investors to use leverage strategically, at relatively low cost. As mentioned, a requirement of a futures contract is that the buyers has to prove they can actually make the purchase in May. After all, the market would break down if all of these future purchases were ordered but then not actually made.

To facilitate this, buyers in the future markets establish loans through banks or other entities that function like lines of credit, using shares of stock or something as collateral (yes, it is more complicated than this in real life, but bear with me). The rates for these loans are much lower than what individual investors can access on their own. In addition, buyers can use equity collateral and cash holdings to leverage their positions. For example, they can use X amount of value in shares of stocks to get 1.5X or 2X (or whatever) of buying power on the futures market.

Of course, using leverage involves costs and risks. You have the interest rate that needs to be paid for the loan, and though it is almost always lower than anything an individual investor could get on their own, it is still a cost. There is also counterparty risk with futures, in which you have an agreement for a future contract but then the other party doesn’t fulfill their side of the deal. In times of extreme market stress, meanwhile, the use of leverage may just freeze up, and a quick margin call by the lender may trigger a forced sell-off of the collateral behind the loans, possibly at steep discounts.

Leverage is thus not without its costs or its risks, but it is also a crucial part of lots on investments. If you buy a house, that mortgage you get is leverage, and at a pretty high multiple, say +400% if you put the standard 20% down. Companies that you invest in are often highly leveraged: Colgate-Palmolive has around +800% leverage, and Home Depot is around +3200%. The type of leverage in these ETFs is also very different than a margin loan, one of the traditional ways that individual investors extended their reach. With those, if your investments go to zero, you’re still on the hook for what you borrowed, but with these, your downside is limited to what you invested.

Putting the Pieces Together

OK, but then how exactly do these Capital Efficient ETFs work? Basically, the money invested in a blended capital efficient ETF is split into two parts: one is used to purchase assets with the intention of holding on to them and using them as collateral; the other is kept in cash to pay for the transaction fees and to meet liquidity requirements as part of investing in futures markets.

To put real numbers on it: imagine you want to invest $1000 in NTSX, a fund that uses +50% of leverage on a traditional 60/40 stock/bond mix. The first step will be to use $900 of that to purchase shares of an S&P 500 fund. NTSX will track the rise and fall of that index, but also put that $900 to use as collateral for borrowing. With the loan, plus the $100 in cash, the managers at NTSX can now purchase futures contracts for $600 worth of Treasury bonds. This makes it function like a 90/60 fund, as you get $1500 worth of exposure for just $1000 in actual money.

Exciting, right?

What are the Pros?

  1. By definition, capital efficiency means you can get all the impact of a certain strategy but use less cash to do so. This is the advantage of investing via futures, instead of buying and holding. You could of course allocate 100% of your portfolio to a fund like NTSX, giving you $150 of market performance for just $100. Or, you could take two-thirds of that $100, send that to NTSX to gain access to a 60/40 portfolio, and still have $33.33 leftover to invest in other asset classes, such as commodities, gold, real estate or something else. These are the two paths of Risk Parity, as I’ve talked about before.
  2. The principle of capital efficiency and the use of futures markets is nothing new, but up until recently, it wasn’t a strategy available to DIY investors. Fund managers followed the same strategies on behalf of healthy clients, and collected a hefty fee for doing so. With the arrival of these strategies in ETF form, these techniques are now available and at very low cost, all things considered. Fees are not quite as low as vanilla index funds, but not that far off, either, and considering that they allow you access to investing that is difficult to do on your own, I’d say they are pretty cost efficient.
  3. The use of futures can actually be pretty tax efficient compared to traditional purchasing. Futures generate fewer “taxable events” than holding bonds, or even equities, mainly because you are not actually holding the assets, just the contracts that track the price of those assets. Bond investing is usually a very tax inefficient investing strategy, but is not when you use futures - no taxable events.

and the Cons?

  1. Capital Efficient ETFs are cool, interesting, and effective, but they aren’t magic. If you have a capital efficient ETF that invests in two asset classes, then they are only going to be as profitable as the components in them. To take NTSX as an example, 2022 was a terrible year for both the S&P 500 and for Ten-Year Treasuries, so it’s no surprise that NTSX suffered, too.
  2. Relatedly, many capital efficient funds follow a strategy of pairing two asset classes which are assumed to be negatively correlated, meaning they tend to move differently than one another (if stocks zig, then the bonds zag). As long as this is indeed the case, the capital efficient strategies are logical, but the relationship doesn’t always hold, such as in 2022. If stocks have a great year, and bonds have a bad year, then NTSX, like all blended funds, will suffer. In this specific case, the leverage component of the fund would make the problem of two simultaneously declining asset classes worse.
  3. If leverage levels are constant, there will likely be a drag on returns when you use futures compared to “buy and hold,” so if you’re not planning on using any leverage, then using futures wouldn’t make much sense. The drag on returns in this case would be due to the higher transaction costs to participate in the futures market and to the issue of having to roll the contracts over. In other words, going with the futures strategy really only makes sense if you use leverage of some sort, and that comes with its own considerations.
  4. Finally, watch out that you don’t get carried away with leverage, which may be an enticing trap. After all, if a little bit is good, then more is better, no? Without going too much into the weeds, the use of leverage in a portfolio does seem pretty good in the +50 or +60% range, but feels differently at the +250% range since leverage increases volatility, and that’s where things get too chaotic for most people. Capital efficiency is a bit like a car that is fine even going 100 miles an hour, but starts to shake and rattle once you go beyond that. Keep it modest.


That’s the basics on how they work. Stay tuned for the next two posts, where I look at two specific examples and show how they can be used in a portfolio.

Disclaimer: In real life, I own shares in GDE, UPRO and TMF mentioned in the piece, but curiously enough, not in NTSX. Keep in mind that this site is intended for financial education, and this write-up is to explain how you might want to think about this particular fund. It's not necessarily a recommendation.