Leveraged Portfolios

The more I research and back-test different types of portfolios, the more certain I have become that using leverage over long periods of time with adequate protection for your situation is one of the best ways to invest. Even if you are not looking for long-term alpha (performance that beats the index), leveraged strategies can also offer really nice downside protection and add stability to your portfolio.

Leverage is best used by more advanced investors with larger accounts and more experience. It requires a lot of discipline to introduce leverage and maintain your portfolio without blowing it up. You must be able to invest with logic, ignoring our natural desire to get greedy during bull markets and fearful in bear markets.

The Strategy Idea

The protection element will form the larger part of your portfolio equity. You should never open up your portfolio to a loss greater than 50% of your equity.

Protection can be achieved with short-term bonds, T-bills, broad bonds, or some other type of bond strategy. More advanced investors might even introduce a bond barbell with tail-risk approach. This large bond portion will generate a steady 1-3% annual inflation-adjusted return over time.

The bonds will consist of 50% to 80% of your portfolio equity. The percentage of your portfolio that you put into bonds will depend on your risk tolerance. While 50% bonds might be appropriate for an aggressive saver with a high risk tolerance, 80% bonds is better for a retiree or more cautious investor.

Then, with the remaining portion of your portfolio equity (50% to 20%), you invest in a stock ETF and leverage it up 2:1 or even 3:1. You take advantage of bull markets by letting the leveraged stock portion propel your portfolio ahead. But during down markets, you are prepared to let the stock portion go down to nothing.

When you buy your stock ETF with leverage, you will always put in a limit stop-loss order. The price would be set at the number where your stock portfolio drops to nothing. This is 50% of the purchase price where you are leveraged 2:1, or 67% of the purchase price where your portfolio is leveraged 3:1. You could also set it as a trailing limit stop-loss. This means your stop price will go up as your stock ETF increases in price.

Historical Results

Here is a graph of the estimated historical results of this strategy going back to 1970. To keep the back-test simple, I used U.S. stocks (total return) and 1-year T-bills (yield averaged). The simulation based on re-balancing your portfolio at the beginning of every year.

Growth of $100 - Comparison of Leveraged Strategies (Log Chart). Source: TheRichMoose.com, MSCI Inc., FRED (Federal Reserve Bank St. Louis)

Disclaimer: These are models, not realized investor returns. Past model returns do not translate to future real returns. No adjustments were made for taxes or transaction costs.

As you can see, all the leveraged portfolios significantly outperformed the basic U.S. stock index. Apart from the green line (50% bonds / 50% stocks leveraged 3:1) and red line (50% bonds / 50% stocks leveraged 2:1), all the portfolios were more stable than investing in stocks only.

Compound Annual Returns (1970–2017)

Blue (100% U.S. Stocks only):  10.57%
Red (50% 2:1 Stocks & 50% Bonds):  13.10%
Yellow (40% 2:1 Stocks & 60% Bonds):  11.72%
Green (50% 3:1 Stocks & 50% Bonds):  17.51%
Purple (40% 3:1 Stocks & 60% Bonds):  15.56%
Cyan (30% 3:1 Stocks & 70% Bonds):  13.30%

Worst Year (1970–2017)

Blue (100% U.S. Stocks only):  -37.14%
Red (50% 2:1 Stocks & 50% Bonds):  -36.32%
Yellow (40% 2:1 Stocks & 60% Bonds):  -28.73%
Green (50% 3:1 Stocks & 50% Bonds):  -49.19%
Purple (40% 3:1 Stocks & 60% Bonds):  -39.02%
Cyan (30% 3:1 Stocks & 70% Bonds):  -28.86%

The worst-case scenario for a leveraged portfolio of this type is a prolonged multi-year drawdown—particularly if there is no tail-risk hedge in place. For example, if you have stocks leveraged 3:1 in a 50/50 split and we have two years of back-to-back 33%+ drops in stocks, you could see your portfolio get cut in half twice (75% total drawdown from peak).

It’s also dangerous to re-balance too frequently, particularly during drawdown periods. Re-balancing once a year is a good number, every eighteen months is acceptable as well.

Leveraged ETFs or Leverage with Margin

Both leveraged ETFs or using margin to leverage up traditional ETFs are acceptable ways of implementing this strategy. There are pros and cons to both methods. Leveraged ETFs get a bad rap, but it's hard to know if that reputation is deserved or not. They've only existed since 2007 and their performance is pretty comparable to what one would expect.

I would probably use leveraged ETFs in a registered account and standard ETFs with margin in a non-registered account.

Leveraged ETFs Pros

  • Never goes down to $0/unit
  • No stop loss required
  • Outperforms in low-volatility markets
  • Easier to implement
  • Only way to use strategy in a registered account

Leveraged ETFs Cons

  • Higher hidden expenses (MER)
  • Potentially not as tax efficient in a margin account
  • Can track the index poorly in high volatility markets

Standard ETFs Leveraged with Margin Pros

  • More cost-effective ETFs
  • More choice in ETF providers
  • Great for margin account with low interest expenses
  • Better tracking of underlying index

Standard ETFs Leveraged with Margin Cons

  • Interest must be tax-deductible to manage costs
  • Requires a stop-loss mechanism
  • More management of accounts for taxes

Words of Caution

As with any strategy, it's important that you ensure your portfolio is set up appropriately for your risk tolerance. This differs for each individual. There is nothing more reckless than believing you can handle an aggressive strategy only to see yourself panic during even the smallest market downturns.

Periodic re-balancing is very important due to the leverage aspect. However, frequent re-balancing is actually harmful and will hurt your performance. It makes no sense to re-balance more than once per year. In a way, leveraged portfolios incentivize you not to play with your portfolio.

It’s important to understand you must treat each account like its own portfolio. You cannot put a leveraged stock ETF in your TFSA and your bonds in your RRSP for “tax efficiency”. Since the contributions to a registered account are limited, you will not be able to re-balance effectively. In the above example, you could easily see your TFSA go down to $0 with no way to fill it. That would be like starting your TFSA from square one again. All that potential of tax-free growth would be lost.

Using leverage in a portfolio is only for a more advanced investor who understands risk. This is because you must have the appropriate safeguards in place and manage them correctly. Safeguards include use of stop-losses, establishing an appropriate margin of safety, and completely understanding the strategy and how it will perform in up and down markets. Leverage can do significant harm to your wealth when you try to chase quick returns.

Improper use of leverage is the fastest way I know to become broke very quickly. This is called "blowing up your account". Even so-called professionals do this all the time. Leverage is why newspapers run sob-stories about former investment bankers flipping burgers at McD's after every big market correction. It happened in 1974, 1987, 1990, 1998, 2001, 2008, and will happen again.

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New Vanguard All-in-One Portfolio ETFs

I know I promised to talk more about leveraged strategies in February. I have been back-testing these strategies diligently and, believe me, I’m excited to start tracking them so you get an idea of my thought process.

However, Vanguard Canada just came out with some game-changing ETFs for passive investors! Now any investor can buy a single ETF and get great, automated results for a super low price (0.22% management fee).

This is the kind of competition stuff I love and it’s going to trigger a new price war for similar products with Blackrock (iShares Canada) and BMO ETFs. I just had to do a post on this!

It’s also why I stopped tracking the Couch Potato-like portfolios each month in the Portfolio Updates. There is no longer any compelling reasons to buy three or four ETFs and do the re-balancing yourself.

One-Solution Fund Products

One solution funds are a great way to make investing easy for investors. A single fund—usually categorized as “Conservative”, “Balanced”, "Aggressive", or “Growth”—will automatically re-balance stocks and bonds to a specified allocation on a regular basis.

These funds will mix Canadian stocks, U.S. stocks, International stocks, Canadian bonds, U.S. bonds, and International bonds for you. They may also add in other components like REITs, gold, commodities, and other asset classes.

Conservative funds target about 40% stocks and 60% bonds, Balanced funds target 60% stocks and 40% bonds, and Growth funds target 80% stocks and 20% bonds. There are some variations depending on the fund manager, but it looks pretty close to this.

There are also funds that tailor to other needs like Income funds, or Tax-efficient funds. Both are questionable in my view as they tend to be heavily marketed. In my skeptical mind, heavily marketed products are not doing a good job selling themselves so there is often a “catch”. In the case of these products, it’s usually higher fees while pushing the emotional sell of “less tax”. They tend to provide meaningful tax benefits to the small portion of investors who are very, very wealthy, but are often sold to the typical investor with less than $1 million in financial assets.

One solution funds do all the work for you. So instead of trying carefully to re-balance once or twice a year, maintaining balance with new contributions, or letting your allocations get out of wack—you just mindlessly buy the one ETF and get back to knitting, racing bicycles, or whatever else you enjoy. (Money is quite ho-hum after all).

Until now there was no great way to invest in a one-fund solution. You could choose Tangerine Funds and pay 1.07% in fees, you could buy a big-bank/insurance company rip-off mutual fund for 1.5 - 3% in fees, or you could invest in an iShares CorePortfolio product and pay 0.25% plus expensive fees in the underlying products up to 0.65%. In a nutshell, you were getting soaked one way or another on these total portfolio products.

New Vanguard Canada Multi-Asset ETFs

This month, Vanguard began offering a new suite of ETFs labelled Multi-Asset ETFs. These are one-solution funds that are truly low cost. The management fee is set at 0.22% and the underlying holdings are all low-cost Vanguard ETFs. I expect the true MER (Management Expense Ratio) with all costs included to be around 0.25%, but that’s a guess. That would land around $250 in total hidden costs per $100,000 invested.

These new ETFs are a fantastic deal as they are. In my mind, they are so cheap it’s not worth buying the separate ETFs and re-balancing yourself anymore if you're a passive buy-and-hold investor. You don't have to worry about tax triggers, screwing up your portfolio, humming and hawing about which ETF to buy this month, or any other worries that newer investors deal with.

All of these new Vanguard ETFs trade on the Toronto Stock Exchange in Canadian dollars—so no fuss with currency or exchange hassle. I think these new, cheap one-fund ETFs are the answer for most Canadian investors who want to manage their own money.

If you use Questrade or National Bank Direct as your brokerage, you can purchase these ETFs for free! Because you never need to re-balance, you don’t incur any extra costs directly. Basically you pay the MER (automatically deducted from your ETF) and that's it.

Vanguard Growth ETF Portfolio (VGRO.TO)

This is the new Growth ETF offered by Vanguard Canada. Consistent with it’s brand, it targets an 80% allocation to stocks and a 20% allocation to bonds. It’s an ETF wrapper product that holds other low-cost Vanguard ETFs, so let’s take a look at what the approximate holdings will be.

U.S. Broad Stocks:  30%
Canadian Broad Stocks:  24%
Developed Countries Stocks:  20%
Emerging Markets Stocks:  6%
Canadian Broad Bonds:  11.7%
International Broad Bonds:  4.7%
U.S. Broad Bonds:  3.6%

This portfolio is for younger savers with higher risk tolerances. It’s going to provide similar results as the Growth Portfolio I've been tracking monthly to this point. Returns are likely to be quite high in rising stock markets, but during a broad market downturn this ETF could fall around 40% in value.

Vanguard Balanced ETF Portfolio (VBAL.TO)

The new Balanced ETF is going to target 60% stocks and a 40% allocation to bonds. Again, it’s an ETF wrapper product and here are the underlying holdings rounded to approximate allocations.

U.S. Broad Stocks:  22.5%
Canadian Broad Stocks:  18%
Developed Countries Stocks:  15%
Emerging Markets Stocks:  4.5%
Canadian Broad Bonds:  23.5%
International Broad Bonds:  9.5%
U.S. Broad Bonds:  7%

This portfolio ETF will provide similar results to the Moose Income Portfolio, but it won’t have the tilt to dividend income. The downside risk is lower than the Growth ETF Portfolio (VGRO.TO), so this is designed for a middle of the road investor who can stomach a 30% drop in the value of their portfolio.

This portfolio configuration would typically be used by an investor with moderate risk tolerance and a longer timeline, or a retiree with larger savings and a margin of safety.

Vanguard Conservative ETF Portfolio (VCNS.TO)

The Conservative ETF will target a 40% allocation to stocks and 60% allocation to bonds. Here are the underlying holdings and their approximately target allocations.

U.S. Broad Stocks:  15%
Canadian Broad Stocks:  12%
Developed Countries Stocks:  10%
Emerging Markets Stocks:  3%
Canadian Broad Bonds:  35%
International Broad Bonds:  14%
U.S. Broad Bonds:  11%

This portfolio ETF is designed for a more risk-averse investor. I would say it might be most appropriate for a more risk-averse retiree or someone who gets nervous about even the smallest losses. It might also be a good choice for someone who needs to use their money in the mid-term (5-10 years).

In a relatively bad stock market situation, this portfolio will probably drop around 20% in value. That’s really quite small! In my view, if you can’t stomach a 20% drop, you should not be investing. Life is about risk management, not risk avoidance.

The Future of Portfolio ETFs

Vanguard seems to be the trend-setter in Canada when it comes to ETF products. However, you can expect that iShares, and maybe BMO, will soon offer competitive products.

Both iShares and BMO have the building blocks in place for low-cost portfolio ETF offerings, so I think it’s only a matter of time. In the past, iShares especially has really pushed to make the price of their competing products even lower than Vanguard. BMO tends to focus on being slightly different, so they might stick with more specialty products and drop the price a little on their Income Portfolio ETF (ZMI.TO). I guess we'll see.

I would not be surprised to see fees on portfolio ETFs drop to the high-teen range by 2020. This would put the fees just a few basis points higher than the massive portfolio mutual funds offered to Vanguard’s U.S. investors.

All in all, this is a huge win for investors! If you are an ambitious new investor, I would say you can still put all your money into XAW.TO and keep making those monthly contributions. However, once you hit around $50,000, you might want to change gears and throw money into VGRO.TO or VBAL.TO to temper the volatility of your portfolio. You might also choose to wait and see what iShares and BMO come up with…

Comments & Questions

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