Two posts ago we discussed how you might simulate the effects of a hypothetical leveraged ETF from the 1980s to today. Then in another post we discussed increasing diversification by using leverage to free up portfolio funds for other assets. In this post I want to combine both of those concepts with a simple active trading technique. Most of the time active trading causes lower overall returns. However, by adding a trading rule, we will see this hypothetical portfolio improve to an annualized return of 15% with a maximum drop in value of just 23% – even during the flash crash of 1987, the dotcom crash, the 2008 financial crisis, and the COVID-19 crash. Then we will discuss when we think it may make sense to use leverage and active trading.
Before we look at the affect of any active trading techniques on this portfolio let’s review the base case from the previous post with a simple rebalancing plan.
If the UPRO allocation grew above 49.5% or shrunk to 16.5% the whole portfolio would be rebalanced to its targets of 33% UPRO, 52% VUSTX, and 15% gold. As long as the synthetic UPRO balance remained in the appropriate range, nothing was done. Here are the results for this base case.
NEW STRATEGY RULES
Now we are going to run a new test with slightly different rules. This time we will dynamically change the target synthetic UPRO allocations based on whether the market is trending up or down. If the current price of VFINX (S&P 500) is higher than its average for the last 200 days we will say the market is trending up. If it is below the average we will say it is trending down. If markets are trending up we will take on the same risk as before with a 33% synthetic UPRO target. If the stock markets are trending down we will reduce our target to 11% for UPRO and increase cash to 22%.
This leads to some pretty fantastic hypothetical results. Not only did the returns improve, the drawdowns improved dramatically. Below you can see some tables and charts displaying returns and drawdowns of this hypothetical portfolio. Take note that some of the charts are on a log scale to make it easier to see periods far back in history like 1987, dotcom crash, and the financial crisis.
Discussion of Results
There are of course many caveats, such as trading fees, AUM fees if you have an advisor, taxes if it is done in a taxable account, etc. These components are extremely important, and Tines Capital takes these into account when working with clients. However, they are outside the scope of this simplified example.
Despite the amazing hypothetical returns of this portfolio there are still risks. Leverage costs could become too expensive. Curve-fitting may have led to bad results. The period tested may have luckily or unluckily worked well for this set of rules, but the future won’t be so kind. The interest rate environment of the future could be so different from the last 40 years that the bond portion of the portfolio would cause too big of a drag. Tines Capital cannot guarantee any level of return or avoidance of loss.
Despite the many possible problems, the odds still seem to be in favor of a strategy that uses similar principles as displayed in this exercise.
Finally, please do not take this post to mean we believe you should go out and start using leveraged ETFs today. They are not right for everyone and are best left to the use of a professional. This is one of the many ways Tines Capital can help!
What does Tines Capital Do
The exact portfolio listed above is not a strategy of Tines Capital. This was just a simplified example to demonstrate the value of some of the key concepts we use for some clients.
- Leverage: When used appropriately, leverage may lead to higher returns. Certain types of leverage such as margin loans should never be used, because they have too much risk.
- Diversification: Diversification can help stabilize returns.
- Active Trading: Active trading techniques may help reduce volatility.
- Synergy: The use of leverage, diversification, and active trading together may have a synergistic affect.
- Risk Tolerance and Emotions: No matter how good an investment is, if it isn’t within a client’s risk tolerance it is easy for emotions to take over and lead to bad results.
Tines Capital creates many algorithms that go far beyond the simple example in this post. We then make sure that we match clients with the right mix of our algorithms to increase the odds they stick with the program, sleep well, and get good results.
We help clients open the right accounts, and invest in the right blend of investments to suite their needs. That may mean prioritizing stability over growth or prioritizing growth over stability. Whatever your situation, Tines Capital is here to help you. Schedule a free call to learn more or get started.