Hey reddit, I'd like to talk about leverage.
I am very enamored with leveraged ETFs. Not the volatile junk such as 3x gold miners (JNUG) or 3x natural gas (UGAZ), as those do seem to lose money in the long term.
No, I am interested in leveraging moderately-volatile indices. Take a look at 3x S&P500 (UPRO), 3x Nasdaq (TQQQ), and 3x long-dated treasuries (TMF). All of these seem to be doing very well.
However, there is a strong dogma that leverage is a bad idea "because of decay". This is rarely backed up by any backtesting. It's just "leverage is bad, mkay?"
For instance, this money.stackexchange question seems pretty reasonable to me: What is the daily rebalanced leverage ratio that is ideal for the S&P 500 based on past performance? But it has -4 votes. The top answer sets up a false dichotomy, arguing the ideal leverage is either 1x or infinite (what?).
It's very rare to find discussion about leverage which includes backtesting. I did manage to find this article, The Big Myth about Leveraged ETFs.
According to that article, the ideal leverage varies depending on which time period you are backtesting:
- 1885-2009, the ideal S&P500 leverage is about 1.8x
- 1928-2009, the ideal S&P500 leverage is still about 1.8x
- 1950-2009, the ideal S&P500 leverage is about 3.1x
- 1972-2009, the ideal S&P500 leverage is about 2.2x
Another thing to be aware of is sharp single-day drops. On October 19th, 1987, the Dow fell 22.6%. This would have wiped out a 4.4x leveraged account in one fell swoop. A 4x leveraged account would have lost over 90% of its value in one day. Therefore it makes sense that our leverage should never exceed 4x. This agrees with the backtesting, which indicates the ideal S&P500 leverage is between 2x and 3x.
Here is a hypothetical portfolio based on those principles.
- 33% TMF 3x Long-Dated US Treasuries
- 32% TQQQ 3x Nasdaq
- 18% SSO 2x S&P500
- 18% Cash
If rebalanced annually over the past five years, this portfolio would have yielded a 30% annual return and a Sharpe ratio of 1.19. Granted, the standard deviation of monthly returns is a ludicrously high 17% so this portfolio is not for everyone.
I know that there's "no such thing as a free lunch". Using leverage provides greater rewards for assuming greater risk. If another 2008 happens, this portfolio will fall much harder than an unleveraged one. And yet... is moderate leverage really a bad deal?
Submitted May 17, 2017 at 11:10PM by X7spyWqcRY http://ift.tt/2rteBXI
