Using Debt To Make Our Portfolio Go BRRR
Dave Ramsey is gonna hate this one...
Now I Know What You’re Thinking…
I have a hard enough time trying to make money, and now you want me to double down using debt? Yeah right.
And I wholeheartedly agree, making money in the markets is really hard if you’re trying to beat them.
That’s why this strategy doesn’t try to beat the markets, at least in the traditional sense.
Let’s sit back and think for a minute, what’s the one thing we know about the general markets and indexes? It’s that they always go up, maybe not over the short term, but definitely over the long term. Don’t believe me? Take a look at this chart that has tracked the S&P 500 since inception.
You can see that this chart dates back over 100 years, and even significant events like the Great Depression or 2008 financial crisis make barely a blip on the radar. The non-inflation adjusted return of the S&P 500 since 1957 has been 10% and over any 20 year time period the market has never lost money.
Now we know that past results aren’t indicative of future returns, but with this long of a time frame, this is about as sure as we can get. So since we “know” that the stock market always goes up over the long term how can we take advantage of that?
Well, we can ratchet up our debt and use other people’s money to invest for us. Sounds kind of crazy on the surface, but it makes sense right? If we start investing at age 20 and retire at 65 that’s 45 years of uninterrupted growth, that should be more than enough time to weather out any financial storms (just shy of the entire world economy imploding). So when we ratchet up our debt we take advantage of that long term growth and magnify our CAGR. What’s even better, we can expect this strategy to fair better over the next few decades than it would have in the past. The reason being, that the US has an enormous debt burden and can’t survive high interest rates again like we saw in the early 1980’s. Until the US pays off its debt (which is unlikely) we will most likely stay in a “relatively” low interest rate environment.
So Let’s Take A Look At What A Leveraged Portfolio Would Look Like
For this backtest, we’ll use UPRO, which is a 3x leveraged ETF that tracks the S&P 500. They have access to institutional rates on debt (about 1-2% possibly even lower) which allows us to get the most bang for our buck. They also rebalance daily to remain at a 3x leveraged position. This prevents a 33% market decline from wiping out the fund. Every day that the market loses money this fund deleverages a little bit back down to the 3x ratio.
For this backtest we’ll use our good friend, portfoliovisualizer.com.
As you can see, the 3x leveraged ETF magnifies the index’s returns, although not quite 3 times. We’ll explain why that is later, but for now, you can see that if you had done this back in 2010 you would have averaged a 31.64% CAGR on the leveraged fund compared to a 14.04% CAGR on regular old SPY. That’s some crazy good returns! So crazy in fact, that we could turn a one time $10,000 investment into over a quarter million in just over a decade!
This looks pretty good! What are we waiting for? Let’s dump everything we have into leveraged SPY!
Not so fast.
If you didn’t notice, take a look at the max drawdown in the top right.
60.44% That’s enough to make you question your will to live.
Obviously it recovered, but that looks like way too much to be comfortable putting your retirement into…
So what do we do? Are we just stuck?
Well here we turn to…
Modern Portfolio Theory
The idea of Modern Portfolio Theory was created to make a more balanced and risk averse portfolio. Essentially the concept is that high risk high return investments should be balanced with low risk low return investments. On top of this, by adding asset classes to a portfolio that have a low correlation with each other, we can assure ourselves that our portfolio will perform well even during recessions.
The main thing that came of modern portfolio theory is the 60/40 portfolio. Most likely you have heard of this allocation. 60% goes to equity index funds like the S&P 500 and 40% goes to long term treasuries and bonds. Because bonds and equities historically have a low correlation, when the markets crash bonds tend to go up to smooth out the returns.
Likewise, when bonds go down, equities make up for it by their aggressive upward swing.
This portfolio even with reduced equity exposure has had good returns 1987 with an average CAGR of 9.16%. This portfolio only suffers about 1% from the long term stock market returns alone with increased volatility protection.
So let’s do the same for our leveraged portfolio and incorporate some leveraged bonds to stabilize the portfolio. By using leveraged bonds we can equally offset the leverage we used for our equities.
Back to Portfolio Visualizer we go!
As you can see our CAGR on the balanced leveraged portfolio is lower by about 5% annually compared to the straight UPRO portfolio, which is fairly significant. In fact, it’s enough to half the amount of money we would have with the straight leveraged SPY portfolio. However what we’re really looking at is the max drawdown. As I recall in the previous backtest our max drawdown was over 60%. However, we can see that by only reducing our returns by 5% we dropped the max drawdown by nearly 40%! That’s a pretty significant reduction in risk!
So that’s our magic bullet, we balance our portfolio into leveraged bonds and leveraged equities to maximize our returns and lower our risk.
Now to be totally honest… I’m not the one that came up with this idea. The idea of using leverage in this way to increase returns have been around for quite some time.
One of the biggest proponents of it was “hedgefundie” over on the Bogleheads forum. His personal portfolio was 55% UPRO and 45% TMF. He found this to be the ideal ratio to maximize returns and reduce drawdowns.
In fact, if you’re interested you can read more about him here.
But Wait… Why Aren’t The Returns For The First Portfolio Exactly Three Times?
I told you we would get back to this point, and this is the one point that critics hold onto the best with this portfolio.
The reason why the returns aren’t exactly three times is because of something called Volatility Decay.
In a nutshell, volatility decay is the reason why a 10% gain followed by a 10% loss doesn’t equal back to your initial invested capital.
($100 invested up 10% is $110, $110 down 10% is $99 —— $100 invested with 2x leverage up 10% is $120 and $120 with 2x leverage down 10% is $96 as opposed to the $99 before)
This is just a fundamental way that math works, there’s nothing tricky going on here.
Because of these normal “whips and saws” of the day to day movements of the market we see a “decay” due to volatility which gets magnified by the leverage we use.
This might seem scary, but in actuality it just means that relative to an unleveraged index, our leveraged funds will take a longer time to recover during a market slump. However, this “decay” also works in our favor during extended bull markets (like the last ten years) which is why if you look at the returns of UPRO since inception vs the returns of SPY since the same date, it is closer to 5x rather than 3x. You can think of leverage as adding “momentum” to the portfolio. When it drops significantly it takes a lot longer to ramp back up to speed, but when it does, it has a far higher “top speed” than an unleveraged fund.
With a time horizon of about 40 years, that should be more than enough time to ride out any prolonged dips. The one thing we need to be wary of is that as we get closer to retirement we should deleverage the portfolio to protect our nest egg.
If you’re interested in reading more about volatility decay I would highly recommend this article which discusses it in depth.
So To Conclude:
Maybe we should change the phrase from “VTSAX and chill” to “UPRO and TMF and mostly chill except its a bit more of a rollercoaster.”
Nah…
That’ll never catch on.
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Until Next Time!
Disclaimer:
All content is for discussion, entertainment, and illustrative purposes only and should not be construed as professional financial advice, solicitation, or recommendation to buy or sell any securities, notwithstanding anything stated.
There are risks associated with investing in securities. Loss of principal is possible. Some high-risk investments may use leverage, which could accentuate losses. Foreign investing involves special risks, including a greater volatility and political, economic and currency risks and differences in accounting methods. Past performance is not a predictor of future investment performance.
Should you need such advice, consult a licensed financial advisor, legal advisor, or tax advisor.
All views expressed are personal opinion and are subject to change without responsibility to update views. No guarantee is given regarding the accuracy of information on this post