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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Set SMART Goals in 2018

Edited Photo. Source: Flickr - Anthony

Last week, as planned, I dutifully dumped $11,000 into our Tax Free Savings Accounts (TFSA). That's $5,500 for my wife and $5,500 in my own account. As usual, the Bill Payment from our chequing account to the Questrade TFSA accounts takes a few days to settle before it becomes available in the TFSAs.

I get a little lazy when it comes to financial stuff and investing when I'm on vacation, but now that we're back it was time to make our actual investment purchases.

In the past, I used our TFSAs as a bit of a play account. My rationale was that transactions are not taxed in a TFSA, so this was the best place to buy and sell individual stocks. It was also a leftover symptom of the days where all we had were TFSAs and RRSPs. But I'm making a pledge here today that those days are over.

From this year forward, there will be no more single stock buying and selling or "playing" in our TFSAs or elsewhere. I'm moving to a straightforward bi-weekly peek that investing should be. ETFs only. That's it.

It's not that I lost money playing with individual stocks. In fact, miraculously I somehow pretty much kept pace with a buy-and-hold Canadian Couch Potato strategy over the years. In 2016 a bet on Canadian bank stocks resulted in me earning 18% returns.

Our combined TFSA accounts today are worth around $160,000! I'm not complaining about the results. Instead, it's just a life choice and sustainability choice.

Analyzing Stocks vs Focusing on Strategy

When a person buys individual stocks, they often fool themselves into being a sort of amateur stock analyst. I did this, I am a fool.

Reading MD&A reports, financial statements, analyzing PE ratios, checking moving averages, following writers on Seeking Alpha. The whole works.

However, if I'm really honest with myself it's not stock analysis which I enjoyed. Instead, I enjoyed being right. Analyzing a stock, making a purchase, and seeing it go up in price. It was a type of self-validation.

This type of self-validation made me emotional about stocks. It wasn't the outward, plainly visible type of emotion where I behaved like a bipolar depressive individual depending on the stock performance that day.

It was more of a deep smugness when things went my way and a form of worry when they did not. This is foolish.

Instead, I'm going to focus intently on strategy. I'm continually working on cleaning up my strategy so that it requires less work and remains within the boundaries of my loss parameters.

I'm not going to become a Couch Potato buy-and-hold investor. Why? Because it doesn't fit my loss parameters. Also, the traditional form doesn't really lend itself well to leverage and careful use of leverage is an important part of my investment strategy. (Something I will share more on in the future).

Setting A SMART Goal for 2018

One thing I've learned in my investment journey is the importance of setting clear goals. I use the SMART principle because it worked for us.

Specific
Measurable
Attainable
Reasonable
Time Limited

In the past few months I created spreadsheets to track our net worth since marriage. I used it to create the nice graph on the About Daren page.

I was amazed to see the results of SMART goals there. In 2010, we had about $50,000 to our name. It took four years to double that to a little over $100,000. During these four years I hardly did any investing at all and our savings were pumped into our house and our education costs. Meanwhile our investment accounts foundered. We didn't have goals other than to stay out of additional debt and pay our mortgage and car payment.

However, in 2014 we started to get more serious about investing. We started by putting some money into RRSPs and TFSAs. As a result, we doubled our net worth that year.

In 2015, we set the goal of topping up my RRSP and TFSA accounts until they were maxed. It took all year, but we ended up more than $100,000 wealthier that year.

In 2016, our goal was to max my wife's TFSA, keep up with my TFSA and RRSP, sell our house, and start a Cash/Margin account. Again, we saved around $50,000 and ended the year more than $100,000 wealthier and debt free!

In 2017, our goal was to save $60,000 and focus on strategy, including introduction of leverage. We beat our goal by October and ended the year over $200,000 wealthier!

In 2018, our SMART goal is to once again save $60,000. This time I would like to refine our use of leverage and make our investment strategy simpler. That's a little vague, so more Specific and Measureable my goals are to have every position leveraged (by no more than 2:1) and to buy or sell a position no more than once every two weeks (not including stop-loss sales). Given that we've dumped $11,000 into the TFSAs so far, we have $49,000 of saving to go and I'm excited to see the progress!

Your Goals for 2018

While I was inspired by others in my journey, I am not endorsing our path for everyone else out there. People have different life circumstances to deal with and I understand my wife and I are fortunate with our dual income, no kids situation.

This year I encourage you to set a SMART financial goal for yourself. Try to max out a TFSA account ($57,500 cumulative limit if you were 18 or older in 2009). If you are paid bi-weekly, it's an ambitious $2,211 per paycheque.

If that's too much, at least put in the increase for 2018 ($5,500). If you are paid bi-weekly like many, it would take $211 per paycheque to hit that goal.

Open up a Questrade TFSA and begin by purchasing an ETF. A simple, broad global stocks fund is a great place to start. Right now XAW.TO is arguably the best choice out there and last year it returned 15.88% after fees and taxes. That handily beat the 1% or less that your big bank TFSA pays you.

Side Note: I've updated the portfolios page and last month's update now that iShares has released their December returns. The Dual Momentum call is still the same as XEF.TO (Developed Countries Stocks) for January.

I've also cancelled my email service to save costs as my 1-year free trial expired. To get hold of me, please leave a comment.

Comments & Questions

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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.