Traditionally I've been a simple 3 fund Boglehead type of investor, but after reading this sub and other material for the past several years I'm considering transitioning my Roth into a strategy that implements leverage and modern portfolio theory. This post by u/hydrocyanide really started to change my view of risk and return along with following other professionals that post on this board, mainly u/MasterCookSwag, u/hedgefundaspirations, u/hydrocyanide and u/cb_hanson_III, so before I start I'd like to thank you guys for contributing to this board and making it a wonderful place to learn. I am not an investment professional and therefore don’t recommend anyone following the strategies that I talk about without consulting someone who actually knows what they are doing.
The portfolio would be constructed similar to Larry Swedroe's "no fat tails" portfolio. This portfolio invests 30% into equity asset classes that have a very high systemic risk (small cap US stocks and international emerging markets) and the remaining 70% into something like treasury notes or bills that would be inversely correlated to equities during times of crisis. By doing so you hope to eliminate the extreme left and right tail return events, both good and bad, and achieve a very reliable sequence of returns. Historically you would have achieved a very high sharpe ratio and even unleveraged would have a decent compound annual growth rate.
The idea of leverage always seemed distant because as a small investor it seemed too expensive. However, I recently came across the Direxion mutual funds that offer leveraged funds for these asset classes with monthly resetting (to avoid leveraged decay of daily funds) and an expense ratio (1.49%) far below what it would normally cost to use leverage normally. I was surprised to see that these funds were implemented before the financial crisis, so we can test this strategy through that very volatile period.. We see that over the past 12 years, using 2x leverage with these funds and annual rebalancing this strategy beat the S&P 500 with significantly less risk.
Caveats:
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This strategy absolutely depends on rebalancing. Annually seems to produce the best outcome but I don’t have any literature based evidence of that. I find it remarkable how much excess return annual rebalancing provides. By doing so, you outperform the best performing fund of the 3 by 4% CAGR!
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Along with point 1, the initial buy in is significant for a small investor. The minimum purchase for each of these funds is $25,000, so you’d need at least $167,000 to have enough to buy in each of the funds with the proper allocation.
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Doing so in a tax advantaged account seems crucial. Otherwise, taxes would eat you alive when you rebalance.
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I wouldn’t put all of my money into this. I am a government worker and I’d likely keep my TSP money into the traditional TSP investments as a hedge. Barring a market meltdown my Roth IRA should have enough to employ this strategy in a couple of years so there is plenty of time to consider alternate viewpoints before I jump into this.
Pitfalls as I see them:
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These Direxon funds are very small. According to Morningstar they only have $8 million to $25 million AUM. I’d worry about them folding shop with amounts that small.
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The volatility of the individual funds would be insane. During the financial crisis the equity funds lost over 90% at one point. You’d have to be a very stoic investor to hold to the strategy when faced with that, and it is easy to say you can do that when looking at the past.
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The number of asset classes is admittedly low. By excluding so many potential asset classes there is risk of suboptimal returns. Something like the 7/12 portfolio is much more attractive in this regard, but historically it has been much more volatile and therefore not as attractive to leverage.
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This point is entering the space where my knowledge is admittedly limited. These funds use swaps and future contracts to achieve their leverage. As interest rates rise and if inflation ticks up what would that do to their expense ratios? It is 1.49% right now when money is still historically cheap, but what happens when that is not true? Would the expense ratios become prohibitively expensive?
So there you have it. I’d like to elicit the thoughts and criticisms of reddit. What am I missing? Thanks everyone.
Submitted July 02, 2018 at 09:20AM by m1garand30064 https://ift.tt/2KFv4Bh
