Why Leveraged Barbell Portfolios Win

Here's a little secret that every Couch Potato or Canadian Boglehead investor should know.

You Can Win With Leveraged Portfolios

In a rising market, leveraged portfolios handsomely beat Couch Potato portfolios. That should be obvious and I think it's fair to say no reasonable investor disputes this.

However, in a falling market, a properly constructed leveraged portfolio will also win. This defies the prevailing logic. However, the proof is in the data. Drawdowns are significantly reduced in leveraged portfolios when compared to vanilla buy-and-hold indexing.

There is no logical reason to continue absurd charade that no one can beat a Bogle-inspired, Couch Potato portfolio. It can be done, quite easily.

The Power of Leverage

No investor should underestimate the power of leveraged ETFs. These ETFs, whether 2x leveraged or 3x leveraged, can provide amazing returns in bull markets.

UPRO, a very popular U.S.-listed ETF tracking 3x leveraged to the S&P 500 Index, has generated a 40.6% CAGR since inception in June 2009 (yes, almost perfectly timing the beginning of the current bull market). An initial investment of just $10,000 would have grown to more than $200,000 today!

The tech heavy TQQQ, providing 3x leverage of the NASDAQ 100 Index, has generated a 51.1% CAGR since inception in February 2010. An investment of $10,000 just eight years ago would have grown to more than $270,000 now.

However, the problem with these ETFs is easy to decipher. If you have a 3x leveraged ETF, it takes just a 33% decline in the underlying market to make the ETF essentially worthless. The concerns surrounding leveraged ETFs is very real. If $10,000 climbs to $270,000 in eight years, but the $270,000 can become nearly worthless in just a matter of months, then these leveraged ETFs are just "too risky" for the typical investor.

Here is where the pundits are wrong. This oversimplified risk example that gets cited over and over is to every investor's detriment.

Leveraged ETFs are a tool to get more exposure for less outlay. Oversimplified a bit, if you put $10,000 to work in a 3x leveraged ETF, it is similar to putting $30,000 to work in a standard ETF. However, that doesn't mean you should put $10,000 in a 3x leveraged ETF if that is all the money you have!

Focusing on Safety First With Barbelling

I stumbled across the idea of simplified leveraged portfolios primarily through my reading of The Black Swan by Nassim Taleb and Trend Following by Michael Covel. The message of these books is simple: first limit your downside risks then amplify your upside potential. Seems simple enough.

The Black Swan espouses an especially interesting idea: barbell portfolios. Have 90% or more of your portfolio in boring, low-risk government bonds, then invest the remaining amount in very high risk instruments.

Taleb typically bets on market crashes, profiting from the ensuing chaos. For example, Taleb reportedly made approximately $40 - $60 million in profits from a call option bet on Eurodollar contracts and the Japanese Yen during the 1987 market crash. Taleb profited enormously as scared investors around the world piled into safe savings accounts, suddenly driving down interest rates and increasing the value of the Eurodollar contract.

The downside to Talebs strategy is it tends to only make money (albeit a potentially enormous amount) during market disruptions. These only present themselves every few years and the portfolio loses a small amount of money in between these periods. The instruments are also more difficult to access and understand for a typical self-directed investor who might not have the time or desire to learn about the futures options markets and roll over positions on a monthly basis.

However, can the concepts of barbelling be replicated in an easier buy-and-hold fashion? Absolutely!

Leveraged Barbell Portfolio Design

The first step of a Leveraged Barbell Portfolio is to hold short-term or mixed government bonds as your primary allocation. This means the majority of your portfolio will be in boring bonds. You should think of bonds as the amount of money you always want in your portfolio. The money you don't want to lose.

Next, you must decide which instruments you will use to drive your investment returns. There are a myriad of options here, but I believe 3x leveraged ETFs are the best choice for simplicity in registered accounts (where most investors have their money). These 3x leveraged ETFs are traded on the U.S. stock markets. The biggest providers are ProShares and Direxion.

Finally you must decide the amount of exposure to loss that you can tolerate, keeping in mind this portion will become worthless about once per decade on average.

Most investors can adequately come through a 20-30% loss in their portfolio without getting too panicked. However, some investors who are younger and have high savings rates can afford more risk. Whatever number you believe you can lose without great concern, that number is your capped exposure to leveraged ETFs.

The amount of your money you invest in leveraged ETFs should be equal to or less than your loss tolerance.

Using standard ETFs, a 20-25% loss tolerance would imply a hyper-conservative portfolio. However, using leveraged ETFs, you can actually obtain a much higher stock exposure and still achieve great returns.

While your risk tolerance should drive your allocation to risk assets, it is also important to understand how much underlying exposure you are getting to stocks based on the equity you are allocating to these leveraged ETFs.

Source: TheRichMoose.com

Historical Performance

Leveraged ETFs are new. The first products, 2x leveraged ETFs, came to market in the mid-2000s. They were primarily promoted as short-term or even day trading products for experts. This led to a cult of avoidance among self-directed investors, amplified and reinforced by continuous fear mongering.

This makes direct backtesting more difficult. Leveraged ETFs don't always track their underlying index perfectly. During high volatility periods they underperform and during low volatility periods they outperform their target return.

However, by extrapolating data going back to 1970, I have been able to come up with a representative backtest on how Leveraged Barbell Portfolios would have performed over more than four decades.

A portfolio allocated 60% to short-term bonds and 40% to 3x leverage of the S&P 500 Index would have generated a 15.3% CAGR.

A portfolio allocated 70% to short-term bonds and 30% to 3x leverage of the S&P 500 Index would have generated a 13.2% CAGR.

A portfolio allocated 80% to short-term bonds and 20% to 3x leverage of the S&P 500 Index would have generated a 10.6% CAGR.

This compares to a historical compound annual growth rate of 10.4% for the S&P 500 during the same time period and a 9.3% CAGR for a traditional 60/40 portfolio.

While investing all of your money in the S&P 500 would have made you sit tight through three drawdowns exceeding 40% of your equity, the Leveraged Barbell Portfolios would have done much better. The maximum drawdown of the conservative 80% bond portfolio would have been about 25%, the roughly the same as a traditional 60/40 stock/bond portfolio.

Over long periods of time, an increase of return amounting to just 1% per year can have a huge impact on your ending portfolio balance and your quality of life. If you invest $700 per month for 40 years, you will end with a portfolio of nearly $1.4 million at a 6% CAGR. If your investment return increases to just 7%, that portfolio will be worth over $1.8 million.

Thinking outside of the box, limiting your downside, and carefully using leverage with a Leveraged Barbell Portfolio can make you hundreds of thousands of dollars wealthier over your lifetime!

Comments & Questions

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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

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

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