When investors seek to grow their wealth over the long run, mainstream advice for how to allocate their assets usually ranges from a relatively even blend of stocks and bonds to 100% stocks. Introducing bonds into an otherwise all-stock portfolio reduces volatility (and returns), and are recommended for investors who need to preserve capital over short time periods or cannot stomach the volatility of an all-stock portfolio. For those who cannot tolerate the volatility or do not need the returns of 100% stocks this advice works well enough, but what about those who need or want a portfolio with higher risk and higher returns than the classic S&P 500 index fund?
According to Portfolio Visualizer, which I will be using for all the data and images in this post (note: all the data is monthly), the total U.S. stock market from 1972 to 2020 returned 10.12% per year with a standard deviation of 15.59%. The maximum drawdown was 51% in 2009; honorable mentions go to drawdowns of 46% in 1974 and 44% in 2002. Those are some steep drawdowns, but those who stuck through them were rewarded: $10,000 invested in 1972 would have become $1,053,935 today, or $167,819 adjusted for (official) inflation.
Leverage for long-term Investing
This is with an asset allocation of 100% stocks; an even higher stock percentage may lead to yet greater returns. When you think about it, adhering to an upper bound of 100% on any given asset class is rather arbitrary, especially when investors may have an even greater risk tolerance. This leads into a fundamental concept in trading and investing: leverage. Often vilified in the context of financial markets, leverage is a valuable tool, where the same investment in a given asset may be controlled with a smaller amount of capital, or vice versa.
The classic case is borrowing money to invest; for example, by investing $20,000 and borrowing another $80,000 to hold a total of $100,000 of assets, 5:1 leverage is achieved. If the $100,000 portfolio appreciates by 10% to $110,000, you have earned $10,000 on a $20,000 initial investment, or 50% of the actual amount of capital you committed. Leverage also works in the other direction; a decline of 10% leads to losses of $10,000, or 50% of the initial investment. This process might sound exotic but millions of people worldwide do it every year: it’s called using a mortgage to buy a house.
Leverage, or its equivalent, need not be achieved using borrowing money; options and futures contracts may also be used, but that could be a post in and of itself so we will focus on the fundamentals of the concept here. The costs of borrowing money or holding options or futures contracts must also be factored into returns, but for the moment we will ignore that in favor of a demonstration of the power of leverage.
Image courtesy of Portfolio Visualizer.
Portfolio Visualizer doesn’t support asset-class-level leverage, so we will do a backtest of the Vanguard 500 Index Investor fund (VFINX), which has data going back to 1985 rather than 1972. Conveniently the return is 10.80%, so pretty close to 1972-2020 and longer-term average returns; the standard deviation is 15.09%. This is what one would have gotten with 100% stocks. Using leverage to go up to 200% stocks increases the return to 15.89%, at the price of increasing the standard deviation to 30.15%. Notice that the returns don’t increase as much as the volatility; this is due to “volatility drag”, where the volatility creates steeper drawdowns that are harder to recover from. Still, much like going from 50% stocks to 100% stocks one is rewarded for stomaching it. $10,000 invested in 1985 in 100% stocks would have become $374,978 today; 200% stocks would have become $1,834,643, nearly five times more. Such is the power of compound interest.
Over the 1985-2020 period 300% stocks would have performed even better: 17.77% returns with a standard deviation of 45.21%, turning $10,000 in 1985 to $3,239,626. This is almost ten times as much as 100% stocks. Notice, however, that throughout this series the volatility is continuing to increase even as returns are diminishing. An allocation to 400% stocks illustrates where the returns diminish completely: 400% stocks returns 14.52% per year with a standard deviation of 60.28%. Less returns than 200% stocks, and with twice as much volatility! Clearly this isn’t a favorable trade-off. Mathematically this is described by the “Kelly criterion”, which can be used to calculate the point at which returns are maximized. For stocks from 1985 to 2020 this is clearly less than 400% stocks, but interestingly the optimal asset allocation is much more than 100%. Studies disagree as to exactly where this point is over the long term; it strongly varies depending on the period being studied, but over decades-long periods it ranges from 150% to 300%.
This doesn’t mean that an investor must go up to this allocation, merely that there is no point to leveraging beyond that level for even the most aggressive long-term investor, as greater returns will not be achieved.
While 400% stocks were overwhelmed by volatility drag, some might be shocked at the level of volatility needed to do so. The 400% stock portfolio would have suffered an incredible 99.13% drawdown in 2009, and even then still manages to beat 100% stocks by 2020; it is worth noting, however, that even today it would not be significantly higher than it was at the 2000 bull market peak. 300% stocks suffers a 94.94% drawdown in 2009, far less than 400% stocks does but still grievous by most people’s standards, yet manages to achieve the highest returns of any of the studied portfolios over the period; the 2000 peak is exceeded in 2014 and it would currently be well above 2000 levels. 200% stocks, by comparison, achieve lower returns but also lower volatility, suffering only an 80% drawdown in 2009, also recovering to 2000 levels in 2014.
If 150-300% stocks is optimal over a period as long as several decades, how is one to obtain this leverage? You could commit all your capital and take out a margin loan from a brokerage, but one issue with this is that at higher levels of leverage you won’t be able to sit through a grievous drawdown without being margin called and being forced to liquidate to settle your debt; a 50% drawdown, which you have a good chance of seeing over a decades-long time period, wipes out a 2:1 leveraged portfolio. Derivatives such as options and futures can unlock much greater (effective) leverage without the risk of being margin called, but a simpler approach would be to buy and hold a leveraged stock ETF. These funds usually hold derivatives such as futures and swaps, relieving the ordinary investor of the burden of managing these short-term instruments.
A Vindication of the leveraged stock ETF
If leverage is vilified in many quarters, leveraged ETFs are (bizarrely) outright demonized as vehicles suitable only for day trading that over the long term inevitably decay toward zero. This is actually not the case, at least not with leveraged stock ETFs. ETFs designed to track volatility do trend towards zero, as they hold options on VIX futures; options cost money to hold, which drags returns down, and the underlying “asset” (in this case the volatility index) is extremely volatile and has no long-term upward trend. This is a recipe for consistent negative returns. $10,000 invested in UVXY (a leveraged volatility ETF) in 2015 would be $6 today, returning -75% per year. The reason anyone trades these ETFs is that the same ETF, UVXY, returned 225% from January through April 2020, paying off handsomely in the midst of a bear market. Like insurance, much money is lost in the good times to get protection in bad times; indeed, the purchase of a protective put option, often used for this purpose, is the best comparison rather than stocks.
UVXY from January 2015 to April 2020. Image courtesy of Portfolio Visualizer.
Inverse stock ETFs, such as SH, which short-sells the S&P 500 index and is not leveraged, also do poorly for the same reason: stocks tend to go up rather than down over the long term. Since inception in 2007 SH has returned -10.07% per year, but did return 38% in 2008. A leveraged inverse stock fund does even worse; SPXS, which is leveraged 3:1, has returned -44% per year, but would have returned 50% in the first two months of 2009 (it didn’t exist before then unlike SH).
Image courtesy of Portfolio Visualizer.
These are very poor returns, but the reason is that negative returns are amplified, not leverage per se as is often supposed. Below we see a comparison of SH (unleveraged) and SPXS (3:1 leverage) from 2009 to 2020; while SPXS obviously does worse the leverage does what it is designed to do. The return of -43.92% per year is 3.06 times as much as the -14.35% return of the unleveraged version, incidentally quite close to the advertised 3:1 leverage ratio.
As leverage magnifies the downside, so it also magnifies the upside, even over many years. SPXL, which is an ETF that leverages the S&P 500 3:1, has returned 26.75% since inception in 2009, compared to 14.65% for the S&P 500. While this is only 1.83 times rather than 3 times as much (these ETFs rebalance daily and only guarantee 3:1 on a daily basis), it is still superior returns. Moreover, April 2020 was right after a market crash before full recovery has occurred, which is when volatility drag is at its maximum; as of December 2019 returns were 35% per year compared to 14.53% for the S&P 500, or 2.41 times as much. Still not 3:1 over the long term but not too far off.
Image courtesy of Portfolio Visualizer.
While cost of capital and volatility drag negatively impact the returns of these ETFs the trend over a time as long as eleven years is strongly positive. Decay to nothing these things don’t. This record isn’t an artifact of a cyclical bull market, either; although the secular trend has been bullish since 2009, there have also been three bear markets (2011, 2018, and 2020) and one volatile range-bound period (2015-16). The ultimate proof is that a 2:1 leveraged S&P 500 ETF, SSO, was around during the 2008 crash; if you had held SSO from inception in 2007 through April 2020, it would have returned 8.44% per year compared to 7.66% for the S&P 500. Disappointing perhaps given the level of risk but certainly not decaying to nothing.
A leveraged ETF that was around in 2008. Image courtesy of Portfolio Visualizer
Making more Wealth with Less
With that myth busted what are the practical implications? The average investor may not be willing or able to stay the course through the swings of even a 100% stock portfolio, let alone 200% or 300% stocks, so for them replacing their entire portfolio with leveraged stock ETFs is not in the cards. However, many investors who hold 100% stocks could easily stomach greater volatility but are unaware of or have been scared off from using leverage to go over 100% stocks, up to either their own (higher) risk tolerance or the maximum return level as indicated by the Kelly criterion. Going beyond 100% stocks through the use of leverage would be very good for them.
This has implications that are very significant for financial planning. If someone had started investing for retirement in 1985, 35 years ago, and needed $1 million to retire, he or she would have needed to invest $240 per month (adjusted upward for inflation) from 1985-2020 in an S&P 500 index fund to retire in 2020 (technically 2018 since stocks have been almost flat since then). Leveraging that same investment 3:1 would have given our investor $5.3 million in 2020; more to the point he or she would have crossed the $1 million mark in 1998, a full twenty years earlier. Admittedly severe drawdowns were looming in the 2000s, but a more lasting crossing of $1 million occurred in 2013, still five years earlier. Perhaps even more interestingly, achieving $1 million in 2020 using 3:1 leverage would have only required contributions of $50 per month.
Portfolio with contributions of $240 per month. Image courtesy of Portfolio Visualizer.
Portfolio with contributions of $50 per month. Image courtesy of Portfolio Visualizer.
So much for people not saving enough to retire; over a relatively typical 35-year period, higher returns could have covered for an 80% shortfall in contributions relative to the numbers calculated by the mainstream. This whole line of thinking suggests that investing more aggressively might help people meet their financial goals (including but by no means limited to retirement) when they are either unable or unwilling to contribute enough to meet them using more conventional or conservative methods.
Admittedly this would require the discipline to stick through the downturns, but even much more conservative strategies suffer from this problem anyway. It is also worth noting that many ordinary investors may find it easier to stay an aggressive course than to sacrifice other parts of their budget through increasing their savings rate. Mainstream financial planning doesn’t emphasize this fact even within the less-than-100%-stocks box; the advantages of a more-than-100%-stocks strategy are virtually never mentioned. The potential gains from this approach being more widely known would seem to be large.
Leverage for more conservative Investing
Another aspect of leveraged stock investing that is virtually never mentioned is the fact that leverage need not be used to achieve more than 100% stock exposure in one’s portfolio. Taking the example of 3:1 leverage once again, instead of leveraging all of one’s assets 3:1 to achieve 300% exposure, one could leverage one-third of one’s assets 3:1, achieving 100% exposure. This theoretically would perform identically to 100% stocks, except with only a third as much capital being committed, leaving the other two-thirds available for other uses.
If the other uses are spending instead of saving, it is identical to the “less contributions with same results” scenario above, but if it is instead some other investment then things start to become interesting. The simplest case of allocating one-third to a 3:1 leveraged ETF and two-thirds to cash actually lags a simple 100% stock portfolio, but not by very much: since 2009 11.42% for the “synthetic” portfolio compared to 13.09% for an S&P 500 index fund.
Image courtesy of Portfolio Visualizer.
Increasing the allocation to SPXL to 38% (from 33.33%) results in a “synthetic” portfolio that tracks the simple index fund pretty closely, this simulating a 100% stock portfolio.
Image courtesy of Portfolio Visualizer.
If instead of cash riskier assets were used for the unleveraged portion of the portfolio the returns from these assets may be captured while still enjoying the benefits of 100% exposure to the stock market, perhaps representing the best of both worlds. In the example below we compare a portfolio consisting of 38% SPXL (a 3:1 leveraged ETF) with the remaining 62% allocated to equal parts SPY (a simple S&P 500 index fund), TLT (a long-term Treasury bond ETF), GLD (a gold ETF), and cash. This is the “Permanent Portfolio” allocation, which is included by itself in the chart for comparison.
Image courtesy of Portfolio Visualizer.
As we can see the Permanent Portfolio has low volatility for the amount of return it gets (6.94% with a standard deviation of 6.29%), but it suffers from a lack of absolute return. Adding a much more volatile and higher-returning asset like leveraged stocks fixes that problem. Indeed, Harry Browne, the creator of the Permanent Portfolio, recommended such a technique; money that needed to be preserved was to be put in a Permanent Portfolio, whereas money that was more expendable could be put in a so-called “Variable Portfolio”.
Of course, considering that the Permanent Portfolio itself has excellent risk-adjusted returns an obvious alternative would be to invest in a leveraged version of the Permanent Portfolio.
The leveraged Permanent Portfolio
Since Portfolio Visualizer can only accept leverage for individual securities, we are limited by the inception date of GLD (the earliest gold ETF to my knowledge), which is 2005. Fortunately the period from 2005 to 2020 was not too atypical, encompassing some secular and cyclical bear and bull market trends with an eventual 7.97% rate of return on the S&P 500; conveniently it also includes the greatest drawdown in the Permanent Portfolio since at least 1972: 12.7% in 2008, a critical variable in calculating the leverage ratio to maximize returns. Below we see three portfolios: the unleveraged portfolio returns 7.1%, the 2:1 leveraged portfolio returns 12.72%, and the 3:1 leveraged portfolio returns 18.1%. For reference, all returns in this exercise are annual.
Image courtesy of Portfolio Visualizer.
Leverage continues to pay off past 3:1. In this chart we see a 4:1 leveraged portfolio which returns 23.18%, a 5:1 leveraged portfolio which returns 27.88%, and a 6:1 leveraged portfolio returning a still-greater 32.07%.
Image courtesy of Portfolio Visualizer.
Below we see continued returns to even greater levels of leverage. In this chart we have a 7:1 leveraged portfolio returning 35.63%, an 8:1 leveraged portfolio returning 38.34%, and a 9:1 leveraged portfolio returning 39.81%. Notice we are seeing returns diminish as leverage increases at this point.
Image courtesy of Portfolio Visualizer.
To illustrate the point once again, notice these two portfolios, a 10:1 leveraged portfolio returning a slightly lower 39.12%, and an 11:1 leveraged portfolio returning an even lower 32.03% per year.
Image courtesy of Portfolio Visualizer.
Returns of almost 40% per year with the best-performing 9:1 leveraged portfolio are nothing to sneeze at; cost of capital means that the optimal amount of leverage and thus maximum return is somewhat lower than this, but theoretically one might have achieved a 170:1 return on investment in fifteen years, which is mind-boggling. Incidentally the 9:1 leveraged Permanent Portfolio has an asset allocation of 225% stocks, well within the return-optimizing 150-300% range discussed earlier.
Of course, this sort of portfolio is very sensitive to the amount of leverage employed; before 2008’s record drawdown it may have appeared that the optimal amount of leverage for this portfolio was well over 9:1. 2008 would have held a nasty surprise for anyone who invested on this basis, cutting his or her total returns substantially compared to what was expected. The chance of an even worse drawdown occurring at some point in the future may be high, considering the Permanent Portfolio depends on four types of assets to offset each other in the event one or more of them crash. Still, a leverage factor of 2:1, which grants about as much return as stocks but with less volatility, and would have only experienced a 25% drawdown in 2008, would seem safe enough.
The aforementioned alternative approach of putting one’s investment wealth in low and high risk segments might be better, or could even accommodate such “leveraged Permanent Portfolios” as part of the high-risk segment.
The barbell Portfolio
Nassim Taleb takes this line of thought to its logical conclusion with his “barbell portfolio” concept, where instead of investing all of your money in middle-risk middle-reward assets one would invest the vast majority of one’s portfolio in safe (low-risk low-reward) assets with a small minority in very-high-risk very-high-reward assets. This is supposed to minimize the risk of a “black swan” event taking out all of your portfolio. Although Taleb is often assumed to be advocating for a barbell consisting of short-term Treasury bonds and out-of-the-money (and thus highly leveraged) stock options, he (probably deliberately) keeps it quite abstract and conceptual.
The general approach of experimenting with a small segment of one’s resources and exposing that segment to uncertainty, volatility, and “black swans” is sound and can be applied throughout life. This is a way of achieving “antifragility”, the condition of benefiting from uncertainty and volatility instead of being crushed by it or merely surviving it.
A perhaps even slicker “fractal” application of the principle is mentioned by Renan in his interesting post on cryptocurrency trading, I call “nested barbell portfolios”, or a barbell within a barbell. If a portfolio is 90/10 safe/risky, the 90% safe portion could itself consist of 10% riskier investments and 90% safer investments, relatively speaking; the 10% risky barbell could consist of 10% that is even riskier, and so on. I am not certain how practical this approach is in terms of actually finding such a myriad of suitable investments, but it is a variant of the barbell portfolio that is virtually never mentioned.
Conclusion
We have seen in this post that the contention so often repeated that leveraged ETFs decay to nothing and are unsuitable as long-term investments is totally and completely false.
Not only that, but more aggressive investors who find 100% stocks to be well within their risk tolerance would be better off with a portfolio that is at least 150% stocks, possibly up to 300%. Those who need greater returns to reach their financial goals given their ability or willingness to invest would also do well to embrace more than 100% stock portfolios. But leverage is not only for those who wish to invest extremely aggressively; as sophisticated traders and investors have long known, leverage can be used to minimize the amount of capital at risk while staying fully invested, thus serving the interests of conservative and aggressive traders and investors alike. It’s about time these techniques to reduce capital commitment, increase liquidity, and provide both security and prosperity were introduced to the masses so they too can reap the bounty.
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