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.

Comments & Questions

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The Year of Easy Wins

Edited Photo. Source: Flickr - Rainer Schutz

This will be my last post of 2017. My next post will be in January starting with our regular monthly updates.

The Year Everything Goes Right

Let's be honest, 2017 has been another amazingly easy year to make money investing. It seems just about everything has gone up, even in Canadian dollar terms with our dollar rising a few cents on the year which reduces the gain on international investments.

U.S. stocks are up around 15%, developed markets are up 19%, Canadian stocks are up over 7.5%, emerging markets are up 21%, even bonds are up 2-3% in our rising rate environment. To top it all off, volatility has been incredibly low with the VIX below 20 for the entire year. That's unprecedented stability!

If you were starting out this year and simply bought XAW.TO, taking a stake in over 8,100 companies around the globe, you would have made an easy 17% this year! It would have been free to purchase if you used Questrade as your low-cost online brokerage.

We’ve also been hit by crypto-mania. You could have bought any number of “currencies” like Bitcoin, Ethereum, Litecoin, Bitcoin Cash, Bitcoin Gold, Ripple, NEO, Zcash, Stellar, Waves, Qtum, and a myriad of other names and tripled or even 10x your investment in mere months. (Yes, these all and many more have market caps over $1 billion). You can't make this stuff up.

Millions of people who can barely keep their iPhone properly updated and their laptops virus-free are putting their life savings into fictional digital money. Some boldly pretend to understand the ins-and-outs of this technology and justify its value; most are just blindly chasing the crowd.

A Reality Check

All this investment dreamland stuff calls for a bit of a reality check. I don’t mean to scare people from investing, taking smart risks, or saving aggressively for retirement. But realize that it isn’t going to stay this easy.

Stock markets and bond markets go through cycles which average out to a long-term return of around 3% to 7% depending on the investment mix and corrected for inflation. It’s impossible for the broad market to give returns much higher than that for an extended period of time. A few years in a row of +10% or +20% returns are always followed by a year or more of -20% or -40% returns.

Given that we’ve had a wicked good run since the beginning of 2016, and really since spring 2009, it’s only reasonable to believe this will come to an end and the market will undergo another severe correction at some point. Right now a return to average valuations for U.S. stocks requires a 60% drop!

I’m not saying it will be in 2018. In fact, the numbers are looking so good that many “experts” are already suggesting 2018 will be another banner year. We’ve got Trumpian tax cuts, big government spending, record corporate profits, inflation and wage gains, and public legitimized trading of cryptos to propel the markets forward forever.

Of course, the experts also saw no risk investing in mortgages for bankrupt, jobless people in 2007, or investing in perpetual money-losing tech firms in 1999 based on website eyeballs.

Socioeconomic Problems

Despite having some of the lowest unemployment rates in modern history, with historically low unemployment for some time now, many are suggesting we have just entered a new economic boom. As if things were so terrible from 2011-2016.

Some are still under the illusion that we need to have growth rates of 4% or more in the developed world. This despite low birth rates, the economic drag of an aging population, out-of-control spending, and a voting public that expects super-low tax rates but blindly dives into debt.

From the beginnings of time, parents and grandparents demanded a better future for their children. Now they demand putting the burden of their selfish desires on the next generation. Insane public health care services, social security, OAS, CPP, tax cuts, and lucrative pensions are enjoyed by older generations today.

Meanwhile the adults of tomorrow are saddled with student debt, over-priced housing, and trillions in government debt and future social obligations. Historically these things tend not to shake out too well.

If you are young and contributing to a defined benefit pension plan today, don’t foolishly count on it being there for you in its promised form when you are ready to retire yourself. Even the most coveted government pensions are in deep trouble. After nearly a decade of incredible investment returns, there is hardly a pension out there which is fully funded in actuarial terms. A large drop in global asset valuations would do incredible damage.

Investing With Caution

Now more than ever is a good time to invest with caution. This isn’t being fearful; it’s being smart.

Follow a disciplined investment strategy that has proven to perform in down cycles. Trend investing and dual momentum strategies are reasonable choices.

You should hedge against the downside risks that are always very real. This means putting in wide stop-limit orders or tracking stops yourself to get out of your investment positions methodically if things correct.

If you’re a more advanced buy-and-hold investor, use 0.5% of your portfolio to pick up some six-month forward out-of-the-money SPY or QQQ puts and roll them every quarter. They’re as cheap as they’ve ever been right now and a good form of portfolio insurance costing 1% or less of your total portfolio.

Having A Moose Mentality

All this said, I don't spend a lot of time worrying about these risks; you shouldn't either. It's easy to follow a plan where you check your brokerage account only once or twice a month and go on living your life for the rest with an eye to a promising future. I do it, so can you.

I believe in the importance of looking after myself first. That means being financially responsible, cutting out the frivolous crap in life, and slowing life down wherever possible. It means looking after my physical and mental well-being. Stress is a choice and I choose 'No'.

In a world where money is the biggest cause of chronic stress, hopefully the nuggets of info every week on this site have helped you say 'No' to money stress as well.

This season, commit to being generous to those you actually care about – family and friends. I challenge you to pick up the phone and cancel your regular donation to that faceless charity who knocked on your door years ago. I bet you don't know where your money actually goes and the accountability is often shaky.

Instead, look around to the people that matter to you and see where you can help. It might be a grocery gift card to the friend that was laid off, a few weekends of your time helping someone save thousands repairing their house or vehicle, bringing a warm meal to someone who is sick, or sharing a cup of coffee at home listening to a friend's concerns and showing them your love. That's the best kind of charity. Use your talents to form the community you want to be a part of.

This Christmas season my wife and I will be trekking a few thousand kilometers to be with our families. We'll share laughs and squabbles, eat like kings and regret it, drink too much and wake up lousy, be active but still gain a few pounds, enjoy the outdoors and relax.

Wishing you and your family a Merry Christmas and fantastic holiday season!

- Daren


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Comments containing promo links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.