Leveraged ETFs have opened the doors to many unique options. Many of these possibilities are overlooked by advisors and investors. In this post I want to discuss whether it is possible to increase overall returns, while also reducing maximum drawdowns by using leveraged ETFs and diversification. We will also discuss a hypothetical asset allocation that may have returned 10% since 1986, while maintaining a 67% cash position.
Leveraged ETFs Alone Have too much Volatility
In the previous post we talked about how a 3X leveraged ETF of the S&P 500 may have performed from 1980 until today. In this post we are going to cover the period of December 1986 until today. Below you can see the results of the synthetic leveraged S&P 500 ETF versus the stock market for this period. Yikes!
There would have been a lot of pain investing 100% in a leveraged S&P 500 fund. As shown above, it takes over 15 years to recover from the drawdown that starts in 2000. Plus in 1987 there was a single day drawdown of about 61%. Virtually no one could have slept well investing most of their money like this.
67% cash portfolio
What happens if instead of a 100% allocation to a 3X S&P ETF we use a 33% allocation and 67% cash. We will rebalance if the leveraged ETF allocation of 33% grows by half or shrinks by half (49.5% or 16.5%). Other than that we just let it ride and leave the cash in a 0% interest account. What do we get? We get a portfolio performance that looks almost as good as the regular S&P 500.
At first glance this may seem pointless, but it is a stepping stone to lots of possibilities. Even though the portfolio had a huge 2/3 cash position, the leveraged ETF enabled the overall portfolio to mostly keep up with the market.
Imagine a fearful investor in 2010 that was convince the stock market would crash below 2008 levels. Perhaps they could be convinced that it would be appropriate to at least invest a third of their cash in a leveraged ETF using this method. That would have been great for them. Consider an alternate case starting in 2007. It may be easier for an investor to later in 2008 to buy into the dip because 2/3 of their funds had been left in cash to begin with.
I am by no means recommending people have such large cash positions. I would of course recommend a better utilization of the cash. Cash can usually be better utilized in an interest bearing account, paying off debt, or invested in other assets with low stock market correlation the results would be even better. My point is that leveraged ETFs can be used to free up some of a portfolio for other purposes.
Put the Cash to Use
Let’s look at having 33% leveraged S&P, 15% in gold, and 52% into Vanguard’s Long-Term Treasuries fund VUSTX. This treasury fund essentially buys bonds of the US government, which is like lending money to the government. Treasuries are considered very secure because the government owns the printing press. However, VUSTX does invest in the most aggressive types of US Treasuries. So this particular fund is still fairly volatile. However, treasuries often have a low or even inverse correlation with the stock market, Similarly, gold can be good in times where people don’t trust businesses or the government to be a good investment.
This very simple rule based system (algorithm) did wonders. It is a great example of how utilizing leverage to free up part of a portfolio for more diversification could lead to better results. There are certainly times that this system did worst than US stocks, but it did significantly better overall.
It is impossible to know what the future holds, but I believe investors and advisors that utilize the lessons learned in this could come out ahead. In some future posts we will discuss why some active trading techniques could be paired with this to potentially improve results, even though active trading overall usually underperforms passive investing.