Is There A Good Way To Use Leverage?

Ways to think about portfolio strategy that could help manage volatility.

Mark Yusko Tweeted the following;

This plays into an idea I have been writing about for ages; portfolio efficiency, being able to get market like returns without having full market exposure, essentially risk adjusted returns. As a very extreme (conceptual) example, if you could pick a stock that was going to double and allocated 10% of your portfolio to it, with the rest in cash, and in that same year the market went up 10% you'd have matched the market with only 10% exposed to risk assets. This is of course very similar to Nassim Taleb's barbell idea of being very conservative with 90% and very aggressive, even to the point of leveraging, with the remaining 10%.

There are various tools and strategies that exist to try to capture this effect. Options of course provide leverage to be used or misused. If you have $10,000 to put into a stock but instead you put the entire $10,000 into options then depending on the strike price and the time to expiration you'd be wildly leveraged.

UK ETP provider Leverage Shares has a suite of products that offers 2X long exposure to individual stocks. They have a pretty long list of stocks including Facebook (FB) as an example. For purposes of this post lets assume the 2X Facebook ETP does what it is supposed to then an investor with $20,000 to allocate to FB could buy $10,000 of 2X FB and keep the other $10,000 in cash, they'd capture the move in FB with only half of their capital in risk assets. Putting all $20,000 into 2X FB would be like being on margin but would be a cheaper way to go as the expense ratio (0.75% for 2X FB) is typically less than what brokerage firms charge for margin loans. The Leverge Shares ETPs have little to no volume and it might be difficult to access them in a US based brokerage account. Also, remember we gave the benefit of the doubt that 2X FB has done what it was supposed to but really that means do what investors would hope.

If you bought 2X FB back when it launched, is that what you would have hoped for? I think this makes the point that this can be an interesting but difficult to make happen.

Back to Yusko whom I met during my time at AdvisorShares when he used to manage a multi asset fund. And while my interest in this concept pre-dates my friendship with Mark he implemented a version of this in his AdvisorShares fund using 3X levered, broad based ETFs. Enough time has passed that I am not certain which funds he used but this chart comparing Direxion Daily S&P500 Bull 3X ETF (SPXL) and the SPDR S&P 500 (SPY) captures Mark's belief in using these;

In two years, SPXL was up 101% versus 29% for SPY...pretty close to capturing 3X over the long term. All of the boilerplate warnings on these levered, broad based equity funds are correct, are real risk factors but Mark's observation is that they generally capture the effect as charted more often than not.

Another example with ProShares UltraPro QQQ (TQQQ) and Invesco QQQ Trust (QQQ).

The potential application is utilizing leverage by getting what amounts to full equity exposure with just 1/3 of your assets. Mark then blended this exposure with other asset classes with different correlations that resulted in a low volatility strategy. Blending very volatile assets with low to negative correlations will often result in the overall mix having a low volatility.

Not good enough for you? Too much risk? Then you should not implement the strategy. To be clear, this is not a strategy I would implement for clients either but it sets the stage for what I believe to be a more practical application of this technique.

For the life of this blog I have written about one part of my top down approach to portfolio construction. I will add or remove holdings as a means of altering the volatility profile of the overall portfolio. Late last year I bought Square (SQ) for most clients. From the bottom up, I think there are a lot of great things in store for them but from the top down I wanted to add a name that I thought would provide more bang for the buck in the context we are talking I about. Then a couple of months ago I added AGFIQ US Market Neutral Beta ETF (BTAL) on a similar premise, wanting to reduce the overall volatility of the portfolio, BTAL tends to have a low to negative correlation to the domestic equity market. I could have sold SQ but I don't think that story is over and it would have been a big capital gain in taxable accounts.

Another way I would be comfortable with this sort of approach is blending broad based equity ETFs with different volatility characteristics (beta). Earlier this week this week I had a chance to learn about the Salt truBeta High Exposure ETF (SLT) which plays into this idea. It is broad based but it seeks the effect of 1.5X leverage by virtue of owning higher volatility stocks. The way Salt positions it, they believe that you could invert the 60/40 portfolio to favor fixed income but still get the same equity return of a traditional 60/40 mix with a better risk adjusted result. The fund is brand new, I have no idea whether it can do that but it would be intriguing if it could.

If SLT is can deliver then I think that would open up to pairings with other broad based equity funds with different attributes than SLT in pursuit of better risk adjusted results which is something we will continue to explore here.