Even A Little Leverage Goes a Long Way

While most amateur investors try to beat the markets with a complicated timing strategy, or maybe seek a niche set of fundamental factors that have provided a historical edge, or try to copy of a pro, most miss the easy solution that's staring them right in the face: leverage.

Leverage might be the most misunderstood element in the market that can all but guarantee out-performance of the standard markets, especially when adding re-balancing. It's the easy solution that everyone is afraid of.

Leverage is so powerful that even a little bit of leverage can provide a very nice long-term edge. Direxion, a major U.S. leveraged ETF provider, has a large suit of products which are leveraged 3x to an underlying index, including inverse leveraged funds. Three multiples of leverage sounds scary to a lot of people, so through their Portfolio+ program they also are marketing a suite of ETFs that employ just a bit of leverage: 1.25x the underlying index.

That's correct, a measly 1.25x leverage ETF to get an investor easy additional exposure to stocks without the wild swings of 2x or 3x leverage.

The current funds offered are as follows:

PPLC: 1.25x S&P 500 Index
PPDM: 1.25x FTSE Developed All Cap ex-US Index
PPEM: 1.25x FTSE Emerging Index
PPMC: 1.25x S&P Mid-cap 400 Index
PPSC: 1.25x S&P Small-cap 600 Index
PPTB: 1.25x BB U.S. Aggregate Bond Index

As of right now, these ETFs are very small and volume is just a few thousand units per day. Being an investor who uses leverage often, I think these funds are interesting and I naturally had to run some backtests to see their historical performance.

S&P 500 with No Re-balancing: 1950 - 2017

S&P 500, Standard

Data
Annual CAGR: 11.23%
Largest Drawdown: -54.55%

S&P 500, 1.25x Leverage

Data
Annual CAGR: 12.91%
Largest Drawdown: -64.3%

As expected, the S&P 500 with 25% added leverage performed better than the standard index. That extra performance also came with more pain in the form of higher drawdowns.

Lets see what happens when we add super-safe T-bills to the mix and re-balance annually as with a passive portfolio.

S&P 500 & T-bills with Annual Re-balancing: 1950 - 2017

Chart A: 60% S&P 500, Standard & 40% T-bills (60% exposure to stocks)

 

Data
Annual CAGR: 8.86%
Largest Drawdown: -34.2%

Chart B: 60% S&P 500, 1.25x Leverage & 40% T-bills (75% exposure to stocks)

Data
Annual CAGR: 10.07%
Largest Drawdown: -41.6%

Chart C: 48% S&P 500, 1.25x Leverage & 52% T-bills (60% exposure to stocks)

Data
Annual CAGR: 9.07%
Largest Drawdown: -33.6%

Comparison of All Strategies (Logarithmic Chart)

Using Leverage for Your Situation

There are two primary strategies to employ leverage (or leveraged ETFs) in your portfolio.

  1. Use leverage to increase absolute returns. This generally means getting more overall exposure to stocks after correcting for the exposure that leverage provides. This also means larger drawdowns in bear markets. (Represented by Chart B above)
  2. Use leverage to decrease drawdowns. This means getting more exposure to stocks with less money. That leaves more money for bonds. Not only will drawdowns lower, but overall returns will also somewhat increase as a result. (Represented by Chart C above)

Even if you choose the safer strategy, simple use of leverage could increase overall returns by 0.2% (20 basis points) per year. Over 30 years, that translates to a 6% increase in overall wealth with zero additional effort, lower drawdowns, and less stress.

The slightly more aggressive approach, even with stocks leveraged just 1.25x the index, increased returns by 1.2% (120 basis points) per year. After 30 years that translates to a net worth that is 43% higher than a comparable portfolio with no leverage. The drawdowns were a bit higher, but not outrageously so. Using a simple leveraged ETF, this requires absolutely no additional effort.

Even a small amount of leverage can have a big impact over an entire investing timeline (30+ years). The advantages provided by leverage can easily outweigh most other strategies with a lot less work for the investor.

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