Leveraged Barbell 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.

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.

Historical Results

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.

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 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.

Comments & Questions

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6 Replies to “Leveraged Barbell Portfolios”

  1. Why is a stop loss not required when using a leveraged ETF, but is when using a standard ETF leveraged with margin?

    If I buy $10,000 of a 2:1 leveraged ETF should I not still have a limit stop-loss order of $5,000 set?

    Thanks.

    1. Daren (Editor) says:

      No stop losses on this strategy. This leveraged barbell approach is very different from the trend following approach I discuss in other posts. The LBP is sort of like buy-and-hold on steroids. With annual rebalancing and high exposure to short-term bonds, an investor gets a better performing, safer portfolio than a typical Couch Potato.

  2. Sorry when you say no stop losses you only mean when using leveraged ETF’s, as you state when using leverage to buy stock ETF’s you always put in a limit stop-loss order, correct?

    Have you run a backtest on the performance of the same amount of capital in a leverage ETF vs leverage with margin to determine the difference in returns between the two methods?

    You mention the bond holdings are in short-term (i.e. XSB), however, is an aggregate bond ETF (i.e. ZAG) equally as acceptable?

    1. Daren (Editor) says:

      My apologies, I should have clarified. There are no stop losses put on for leveraged ETFs. If you leverage up standard ETFs, you should put a wide stop loss on to ensure you don’t let the margin on the equity ETF drag down your bond ETF. Using standard ETFs is a bit more complex but reduces some of the volatility drag leveraged ETFs can exhibit.
      A broad bond fund like ZAG.TO/XBB.TO/VAB.TO/HBB.TO/ZDB.TO would work well. Overall returns would be higher but volatility would also be somewhat higher.
      I have not yet done a backtest on leveraging up standard ETFs with margin.

    2. Daren (Editor) says:

      Here’s an example of what using a stop loss to protect standard ETFs with margin would look like.
      Let’s say you have an account worth $100,000 and you follow a strategy of 60% bonds and 40% stocks leveraged up 3x.
      You would purchase $60,000 worth of a bond ETF. Using XSB.TO, it is $27 per unit right now so you buy ~2,200 units.
      Now you would buy $120,000 of stocks ($40,000*3). Using XUU.TO, it is $27.50 per unit right now so you buy ~4,300 units. You would set your stop loss at $18.25 per unit to ensure the position won’t drag down your bond holding. Ie. you don’t want to lose more than the $40,000 of your own portfolio equity that you allocated to stocks.

  3. Thanks for your quick responses Daren.

    Appreciate you sharing your knowledge.

    Cheers.

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