Why Leveraged Barbell Portfolios Win

Here's a little secret that every Couch Potato or Canadian Boglehead investor should know.

You Can Win With Leveraged Portfolios

In a rising market, leveraged portfolios handsomely beat Couch Potato portfolios. That should be obvious and I think it's fair to say no reasonable investor disputes this.

However, in a falling market, a properly constructed leveraged portfolio will also win. This defies the prevailing logic. However, the proof is in the data. Drawdowns are significantly reduced in leveraged portfolios when compared to vanilla buy-and-hold indexing.

There is no logical reason to continue absurd charade that no one can beat a Bogle-inspired, Couch Potato portfolio. It can be done, quite easily.

The Power of Leverage

No investor should underestimate the power of leveraged ETFs. These ETFs, whether 2x leveraged or 3x leveraged, can provide amazing returns in bull markets.

UPRO, a very popular U.S.-listed ETF tracking 3x leveraged to the S&P 500 Index, has generated a 40.6% CAGR since inception in June 2009 (yes, almost perfectly timing the beginning of the current bull market). An initial investment of just $10,000 would have grown to more than $200,000 today!

The tech heavy TQQQ, providing 3x leverage of the NASDAQ 100 Index, has generated a 51.1% CAGR since inception in February 2010. An investment of $10,000 just eight years ago would have grown to more than $270,000 now.

However, the problem with these ETFs is easy to decipher. If you have a 3x leveraged ETF, it takes just a 33% decline in the underlying market to make the ETF essentially worthless. The concerns surrounding leveraged ETFs is very real. If $10,000 climbs to $270,000 in eight years, but the $270,000 can become nearly worthless in just a matter of months, then these leveraged ETFs are just "too risky" for the typical investor.

Here is where the pundits are wrong. This oversimplified risk example that gets cited over and over is to every investor's detriment.

Leveraged ETFs are a tool to get more exposure for less outlay. Oversimplified a bit, if you put $10,000 to work in a 3x leveraged ETF, it is similar to putting $30,000 to work in a standard ETF. However, that doesn't mean you should put $10,000 in a 3x leveraged ETF if that is all the money you have!

Focusing on Safety First With Barbelling

I stumbled across the idea of simplified leveraged portfolios primarily through my reading of The Black Swan by Nassim Taleb and Trend Following by Michael Covel. The message of these books is simple: first limit your downside risks then amplify your upside potential. Seems simple enough.

The Black Swan espouses an especially interesting idea: barbell portfolios. Have 90% or more of your portfolio in boring, low-risk government bonds, then invest the remaining amount in very high risk instruments.

Taleb typically bets on market crashes, profiting from the ensuing chaos. For example, Taleb reportedly made approximately $40 - $60 million in profits from a call option bet on Eurodollar contracts and the Japanese Yen during the 1987 market crash. Taleb profited enormously as scared investors around the world piled into safe savings accounts, suddenly driving down interest rates and increasing the value of the Eurodollar contract.

The downside to Talebs strategy is it tends to only make money (albeit a potentially enormous amount) during market disruptions. These only present themselves every few years and the portfolio loses a small amount of money in between these periods. The instruments are also more difficult to access and understand for a typical self-directed investor who might not have the time or desire to learn about the futures options markets and roll over positions on a monthly basis.

However, can the concepts of barbelling be replicated in an easier buy-and-hold fashion? Absolutely!

Leveraged Barbell Portfolio Design

The first step of a Leveraged Barbell Portfolio is to hold short-term or mixed government bonds as your primary allocation. This means the majority of your portfolio will be in boring bonds. You should think of bonds as the amount of money you always want in your portfolio. The money you don't want to lose.

Next, you must decide which instruments you will use to drive your investment returns. There are a myriad of options here, but I believe 3x leveraged ETFs are the best choice for simplicity in registered accounts (where most investors have their money). These 3x leveraged ETFs are traded on the U.S. stock markets. The biggest providers are ProShares and Direxion.

Finally you must decide the amount of exposure to loss that you can tolerate, keeping in mind this portion will become worthless about once per decade on average.

Most investors can adequately come through a 20-30% loss in their portfolio without getting too panicked. However, some investors who are younger and have high savings rates can afford more risk. Whatever number you believe you can lose without great concern, that number is your capped exposure to leveraged ETFs.

The amount of your money you invest in leveraged ETFs should be equal to or less than your loss tolerance.

Using standard ETFs, a 20-25% loss tolerance would imply a hyper-conservative portfolio. However, using leveraged ETFs, you can actually obtain a much higher stock exposure and still achieve great returns.

While your risk tolerance should drive your allocation to risk assets, it is also important to understand how much underlying exposure you are getting to stocks based on the equity you are allocating to these leveraged ETFs.

Source: TheRichMoose.com

Historical Performance

Leveraged ETFs are new. The first products, 2x leveraged ETFs, came to market in the mid-2000s. They were primarily promoted as short-term or even day trading products for experts. This led to a cult of avoidance among self-directed investors, amplified and reinforced by continuous fear mongering.

This makes direct backtesting more difficult. Leveraged ETFs don't always track their underlying index perfectly. During high volatility periods they underperform and during low volatility periods they outperform their target return.

However, by extrapolating data going back to 1970, I have been able to come up with a representative backtest on how Leveraged Barbell Portfolios would have performed over more than four decades.

A portfolio allocated 60% to short-term bonds and 40% to 3x leverage of the S&P 500 Index would have generated a 15.3% CAGR.

A portfolio allocated 70% to short-term bonds and 30% to 3x leverage of the S&P 500 Index would have generated a 13.2% CAGR.

A portfolio allocated 80% to short-term bonds and 20% to 3x leverage of the S&P 500 Index would have generated a 10.6% CAGR.

This compares to a historical compound annual growth rate of 10.4% for the S&P 500 during the same time period and a 9.3% CAGR for a traditional 60/40 portfolio.

While investing all of your money in the S&P 500 would have made you sit tight through three drawdowns exceeding 40% of your equity, the Leveraged Barbell Portfolios would have done much better. The maximum drawdown of the conservative 80% bond portfolio would have been about 25%, the roughly the same as a traditional 60/40 stock/bond portfolio.

Over long periods of time, an increase of return amounting to just 1% per year can have a huge impact on your ending portfolio balance and your quality of life. If you invest $700 per month for 40 years, you will end with a portfolio of nearly $1.4 million at a 6% CAGR. If your investment return increases to just 7%, that portfolio will be worth over $1.8 million.

Thinking outside of the box, limiting your downside, and carefully using leverage with a Leveraged Barbell Portfolio can make you hundreds of thousands of dollars wealthier over your lifetime!

Comments & Questions

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Canadian Dollar Impacts

You may have wondered in the past few weeks why the global stock markets seem to be recovering but your investment accounts are not getting any bigger.

Since the beginning of April, stocks have been doing quite well. The S&P 500 is up around 5%, the Nasdaq 100 is up a bit more than that, the MSCI EAFE index is up around 4%, while the Emerging markets are more or less flat.

However, this gets completely turned around once we take a look at markets in Canadian-listed products. While XUU.TO and XEF.TO are basically flat, VEE.TO is actually down so far this month. What is going on?

The answer boils down to one factor... the value of the Canadian dollar has been climbing. This fits with the common themes we have been seeing from the Canadian dollar in the last few years. When the stock markets do poorly, the value of the Canadian dollar falls as well cushioning investor accounts from the full impact of the markets. The inverse is also true.


Source: Yahoo Finance

The chart above is the Year-to-Date movement of the Canadian dollar relative to the U.S. dollar. The Canadian dollar fell in value quite a bit from the end of January though the middle of March before suddenly changing direction.

From the beginning of April, our dollar has leaped up around 2.5% against the U.S. dollar, jumping above the short term moving average I like to use: the 10-day EMA. The 10-day EMA is a great indicator of shorter term market movements. This is a big, solid move for any currency including the secondary currencies (Canadian dollar, Australian dollar, New Zealand dollar, Hong Kong dollar, Singapore dollar, and the Swiss franc are in this group).

The CAD/USD relationship directly impacts Canadian ETFs which hold U.S. stocks. My favorites include XUU.TO, ZSP.TO, HXS.TO, and XDU.TO.


Source: Yahoo Finance

The direct impact of a falling currency on stock portfolios can be seen in this chart. I compared XUU.TO (dark blue line) to its currency-hedged version XUH.TO (light blue line) from the recent market peak on January 29 to the recent low on April 2. The unhedged version with the full impact of the falling Canadian dollar during this time declined approximately half the amount of the underlying market!

The currency impact translates to the muted overall effect on your portfolio as mentioned above.

CAD vs. Euro

Source: Yahoo Finance

The Canadian dollar has also increased approximately 1.5% against the Euro since the beginning of April. This is important because the Euro is the largest currency component of the MSCI EAFE index.

Other larger currencies represented in the EAFE index are the Japanese yen and the British pound.

Currency Impacts When Investing

The question of currencies is always an important one when considering your investment strategy. It's also a topic that gets a lot of investing commentators very fired up.

Currency is an important consideration for Canadian investors precisely because we are a secondary currency market. Our currency sees large swings in value which are largely driven by resource market conditions.

Commentary surrounding currency hedging by U.S.-based personal finance folks should be ignored. It's like comparing apples to oranges. The U.S. dollar is by far the largest impact and most important currency in the world--setting the global prices for nearly all commodities and a significant volume of industrial trade. U.S. investors should rarely hedge their portfolios for precisely this reason.

As a trend following investor, I generally just invest with the longer-term trend including currency trends. This makes the decision about hedging easy. I pick a hedged version of international index ETFs when our currency is trending up and a standard index ETF when our currency is trending down. It's impossible to catch all the trends perfectly, and it's not possible to hedge effectively with Emerging markets, but this strategy largely serves the purpose.

For more static investors, I believe the answer is to mix products to get varied currency exposure. Buy bond ETFs that hold Canadian bonds where possible. When buying international bonds, use hedging to minimize currency impacts.

When purchasing stocks, generally stick with ETFs which are not currency-hedged. This gives you exposure to the major currencies like the U.S. dollar, Euro, Japanese yen, and British pound.

If your portfolio is large (seven figures or more) with a smaller than typical bond allocation, consider currency-hedging a portion of your stock ETFs. Targeting between one-third and one-half of your total portfolio in Canadian dollars is not a bad choice if you primarily spend Canadians dollars.

Alternatively, you can invest in a Leveraged ETF Strategy. By increasing your bonds (held in Canadian dollars) and using U.S.-listed leveraged ETFs, you can have a high Canadian dollar exposure providing interest income as well as full stock exposure in international currencies. Not only are your long-term investment returns likely to be higher than a boring Couch Potato portfolio, your risk levels are actually lower.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.