Explaining a Barbell Portfolio

I get frequent questions about my personal portfolio, especially the trend following portfolio in my non-registered investment account. One of the questions I get is why I don't use the Leveraged Barbell Portfolio strategy that I talk about in the blog.

My answer is that I do use a leveraged barbell portfolio strategy in my non-registered account. It's simply not as passive as the strategy I shared.

A barbell is an iconic, effective, and simple piece of weightlifting equipment. The lifter loads a 220 cm bar with an equal number of iron plates on each side to the desired total weight.

If you look at the loaded bar lengthwise, it is mostly just an empty bar. But that weight on the extreme ends of the bar can weigh hundreds of pounds. A small part of the total bar carries all the weight!

An investor could break down this same idea into an investing concept. Most of a barbell portfolio is invested in pretty boring assets that generate a reliable, moderate return.

However, like the ends of the barbell, a smaller amount of the total portfolio is invested in risky assets that can generate large returns and does the heavy lifting for your portfolio.

The barbell portfolio tries to minimize big losses, provides great risk control, and the investor has the opportunity to experience great returns.

Barbell Portfolio Structure

Safe Assets

In a barbell portfolio, 60 to 90 percent of the portfolio should be invested in safe assets. We are looking for stability and security with dependable returns.

Of course, the returns for assets with these characteristics won't be that high. Even 2 to 3 percent real returns (4 to 6 percent gross nominal) are okay here.

The exact amount of safe assets you choose should depend on what you use for your risky assets and your overall risk tolerance.

A portfolio with just 60 percent in safe assets could see a 40 percent decline.

Some examples of good safe assets include:

  • Broad bond funds (AGG, BND, XBB.TO, HBB.TO)
  • Short-term government bonds (SHY, VGSH, XSB.TO, VSB.TO)
  • Short-term corporate investment grade bond funds (IGSB, VCSH, XSH.TO, VSC.TO)
  • Intermediate-term government bonds (IEF, VGIT, XGB.TO, ZGB.TO)
  • Split bond portfolio (half short-term bonds, half long-term government bonds)

Risk Assets

The remaining 10 to 40 percent of your portfolio will be invested in risk assets. On this side, we are looking for high period returns.

The assets invested in here should, at minimum, have shown themselves to double in value in a year or less on several occasions in the past.

The precise assets you use will depend on your overall risk tolerance and your allocation to safe assets. If you are allocating 40 percent of your portfolio to risky assets, you should choose less extreme options.

Some examples of potential high return assets include:

  • Leveraged ETFs
  • Options
  • Small cap stocks
  • Technology stocks
  • Biotech stocks
  • Private equity
  • IPOs

Principles

Always protect your portfolio! Commit to a very hands off approach with your safe asset allocation and do not pursue outsized returns here. You do not want to lose this money.

Generally speaking, the higher your allocation to the safe assets is, the more durable and stable your overall returns will be. While a modified barbell portfolio might contain just 60 percent safe assets paired with a 40 percent exposure to a leveraged index fund, a true barbell portfolio would have at least 80 percent safe assets paired with the highest risk choices like options.

Leveraged Barbell Portfolio

In the Leveraged Barbell strategy which I so enthusiastically share on this blog, I talk about an extremely passive method for employing the barbell strategy.

Using leveraged ETFs and short-term bond ETFs, you only need to adjust your portfolio allocation once per year. That's as easy as the Couch Potato strategy, but your returns and protection are better.

Since the Leveraged Barbell Portfolio I share uses broad equity index ETFs, the 3x daily leveraged S&P 500, you can safely allocate higher amounts to the risk side. Still, I would recommend the average investor allocate between 60 and 70 percent of their portfolio to bonds.

My Leveraged Barbell Portfolio

Knowing that a barbell portfolio is one mostly invested in safe assets with a smaller allocation to risk assets, you will see that my trend following portfolio is actually a leveraged barbell portfolio.

In my trend following portfolio, I track U.S. equities, developed international equities, emerging international equities, gold, silver, and currencies.

Safe Assets

Currencies can be thought of as a safe asset in many ways. I do not use any leverage when making bets on currencies, they are easy to trade on the upside or downside as currencies are pair-traded, and the markets are extremely liquid and price efficient. I also take pretty small positions on currencies.

I use currencies, including the U.S. dollar and Canadian dollar, as they are more flexible and tax efficient than investing in bonds in my non-registered account. I would rather earn capital gains than interest income.

To get some perspective on my current position, I am a little over 90 percent in currencies at the moment. Most of that is U.S. dollars.

Risk Assets

I use leverage to invest in each equity and commodity position. This was done with leveraged ETFs and I am going to start using LEAPS options for more efficient capital use.

As I slowly get out of the last of my leveraged ETFs and the market begins to send upside signals on equities, I will be investing via LEAPS options only. It is likely that my portfolio will rarely be more than 20 percent allocated to risky assets.

I am very cautious about shorting (betting against) many assets, particularly equities. It is extremely difficult to short equity index funds and make money. This means I will primarily only bet on the upside signals for equities; when the signal is down, I will be in cash.

I see potential for upside and downside bets on gold and silver when using LEAPS options. This means as I get my LEAPS options trading going, I may be invested in gold and silver calls or puts at all times, depending on the signal and sized based on volatility.

In effect, this will be a barbell portfolio where the risk assets (up to about 20 percent of the portfolio) are LEAPS options that are entered or exited based on trend following signals.

Comments & Questions

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Smith Manoeuvre: Is a Dividend Portfolio Required?

I get asked occasionally about investment options in the Smith Manoeuvre. Do you need to invest in a dividend strategy? What about ETFs? Can you use a trend portfolio?

The investment portfolio is an important component of the Smith Manoeuvre strategy. In order to have the HELOC loan interest qualify as a tax deductible expense (the whole point of the Smith Manoeuvre), you need a dedicated non-registered investment account where your borrowed money is invested.

This money should be carefully tracked at every step of the way to ensure full tax compliance. This means direct transfers from your HELOC to your Smith Manoeuvre investment account. Dividends from the Smith Manoeuvre investment account go to your Smith Manoeuvre chequing account. Both sides of your HELOC get paid from your Smith Manoeuvre chequing account.

These accounts are only for the Smith Manoeuvre process. No outside money, no mixing accounts to save a couple bucks on any account fees, and no taking money from your HELOC to pay for Mexico vacations or concrete countertops.

The structure is not necessarily simple, as you can see by my chart below. But the rewards are significant!

You can save thousands of dollars a year in taxes just for moving money through a few extra accounts once a month. This tax money can be used to pay off your traditional mortgage faster and boost your investment accounts.

Once you have all the accounts set up and understand the process, it should take no more than a few minutes of your time, a few times per month to complete the transactions.

Source: TheRichMoose.com

SM Investment Account

All of the component accounts of the Smith Manoeuvre are necessary for the strategy to work seamlessly.

As per the CRA's definition of income, every last dollar in your Smith Manoeuvre investment account (money borrowed from Portion 2 of the HELOC) must be invested in an asset that generates one of these types of income: Canadian dividends, foreign dividends, interest income, or certain forms of business income.

It's important to understand the distributions are not required to exceed your interest expenses. It is just some income that qualifies for your loan interest to be tax deductible.

Capital gains (distributed or embedded) or return of capital distributions do not count!

The direct application of income generating assets from your borrowed money is why your Smith Manoeuvre investment account must be kept separate from any other non-registered investments.

ETF Investing in your SM Account

It is certainly possible to invest with ETFs in your Smith Manoeuvre investment account and be tax deductible and successful.

As long as the ETFs pay dividends or interest, whether they are foreign or Canadian-based, they are likely to meet the standard for tax deductibility on your HELOC loan.

Although there are differing opinions on this, I would avoid most funds which are advertised as being tax efficient. This includes swap-based ETFs, T-series funds, or corporate class funds.

Compared with direct stock investing, ETFs may simplify the investing process and decision making, but they are likely to add some complication your tax situation. They are also likely to be less tax efficient compared with other options.

The problem with the vast majority of ETFs is that they distribute several different forms of income each year within each distribution.

Some forms of income are less desirable because they are taxed at higher rate, such as foreign dividends and interest. These are commonly found in international equity ETFs and bond ETFs.

Distributed return of capital, common with ETFs and REITs, causes you more work at tax time and can reduce the tax deductibility of your SM HELOC over time if not adjusted correctly.

Most ETFs and mutual funds are likely to be less tax efficient than investing directly in Canadian-listed stocks. That doesn't mean you should avoid all ETFs, but it does mean you should take this into consideration when planning your investment strategy.

If you invest in ETFs, you should prefer ETFs which are low cost, highly liquid, and pay a low distribution yield.

Avoid bond ETFs where the investment return is mainly in the form of distributions instead of unit price gains.

Investing with ETFs means you can employ a large variety of the strategies I talk about on this blog. That includes buy-and-hold investing with Vanguard Portfolio ETFs and my TADM strategy.

Stock Investing in your SM Account

Investing directly in publicly-listed Canadian corporations is a popular strategy for Smith Manoeuvre investors.

Directly holding Canadian stocks means you can design a very tax efficient portfolio that is very likely to meet the requirements for interest deductibility set out by the CRA.

As long as the company stock you invest in pays a tiny dividend or even states intent to pay a dividend at some point in the future, your SM HELOC interest will be tax deductible.

Directly investing in individual corporations also helps you avoid the potential distribution mix nonsense of many ETFs and REITs. Individual corporations distribute dividends, that's it.

Canadian-listed companies distribute dividends which are eligible for the dividend tax credit. This can significantly lower your tax bill on the distributed investment income, keeping your account tax efficient.

There are countless strategies you can use to invest with individual stocks. Trend investing, value investing, dividend growth, high yield dividend, Buffet moats, large cap equal weight, etc.

The keys to successful individual stock investing include: adequate diversification, systematic buying and selling, and cutting losses on positions when needed.

If your strategy kicks you out of a stock position, don't hold cash in your SM account. Instead, put the money in a more tax friendly bond fund like the FirstAsset 1-5 Year Laddered Strip Bond ETF (BXF.TO) or the BMO Discount Bond ETF (ZDB.TO).

Of the strategies I mentioned, naturally I'm a fan of trend investing. It's generally easy to track, requires little guesswork or "guesstimating", and can result in a pretty smooth ride.

Example

Let's look at a portfolio of ten currently popular Canadian stocks which pay dividends: Royal Bank, Manulife, Power Financial, Enbridge, ATCO, Canadian National Railway, Loblaws, Telus, Brookfield Asset Management, and Fairfax Financial.

Since 2001, if you would have run a 10-month simple moving average screen on these stocks, trading no more than once a month, you would have seen fantastic results.

The portfolio would have a maximum drawdown of 11 percent and a compound return over 10 percent per year.

To achieve that same level of risk in a Canadian Couch Potato portfolio, you would have invested in the "Conservative" model. That's just 30 percent in the stock index and 70 percent in Canadian bonds.

Your compounded return would have been around 5.5 percent per year with that approach. Still decent, but certainly not great.

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.