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.
A Leveraged Barbell Portfolio
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.
Here is a graph of the estimated historical results of various Leveraged Barbell Portfolio strategies 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.
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 Barbell 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 Barbell 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 Barbell 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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