20% annual returns over 40 years...interested?

[Liz L.]

Very interesting; thanks, Wonk!

[Verto]

It seems the markets are poised to really 'test' the leveraged PP idea.

I think this is a great time to see how it performs.

[AdamA]

if you could borrow 10 million dollars tomorrow and put it into the PP would you do it? How about 100 mil? 1 billion? 100 billion?

From HB:

Rule #7: Don't use leverage.

When someone goes completely broke, it's almost always because he used borrowed money. In many cases, the individual was already quite rich, but he wanted to pyramid his fortune with borrowed money.

Using margin accounts or mortgages (for other than your home) puts you at risk to lose more than your original investment. If you handle all your investments on a cash basis, it's virtually impossible to lose everything—no matter what might happen in the world—especially if you follow the other rules given here.

[Wonk]

Just wanted to say I've been following this leveraged portfolio through the high volatility of the last week or two and it's a helluva lot of fun to watch. 8%-12% daily moves in each ETF are common, although the portfolio as a whole is largely meeting it's directive: roughly 2x the daily move of the underlying assets in a traditional 4x25.  Without a doubt there's been more tracking error, although I've also seen much more tracking error in un-leveraged ETFs such as IVV. 

The orthodox PP has been running as smoothly as a finely tuned Rolls Royce.  The leveraged PP has been running as fast as a Formula One Ferrari.  For the latter, quite frankly I'm surprised the wheels haven't fallen off.  It remains to be seen if it will stay on the road longer term with plenty of bumps and curves ahead. 

[Wonk]

Wonk.

LTT's have a pretty consistent inverse correlation to stocks.

Look at the comparison of TLT and UBT however over the last couple of year and its almost as though UBT had a degree of inverse correlation to TLT.

Clive,

Can you elaborate a bit more on that?  I ran an overlay of TLT and UBT for the past year and it seemed consistent.  UBT's inception date was 1.21.10 and it appeared there was a decent amount of tracking error early that was smoothed out within a few months.  What did you see that I'm missing?

[Wonk]

Weird.  Check out the US version of yahoo finance:

http://finance.yahoo.com/echarts?s=UBT+ ... =undefined

It looks like the UK chart has some sort of glitch in the code.  I used UBT & TBT on the US site to try and replicate:

http://finance.yahoo.com/echarts?s=UBT# ... =undefined

[Verto]

I was very confused seeing the first chart... as the second one is what I see in google as well. Weirddd. Silly yahoo.

[stylo]

It appears the "break-even" duration of a leveraged PP would be about 4 years, not including opportunity cost.  That is to say, if you invested $1 in a 2xPP instead of an orthodox PP, you would need to survive 4 years without a 100% loss to recoup your initial investment.  If you are including opportunity cost, you would need a shade over 5 years to exceed the expected return of an orthodox PP along with the return of your original investment.  Any returns after that point would be gravy.

You mean 4 years to be playing with profits only?

I can imagine a nasty fall as gold and tlt tumbles.

[stone]

Clive, might an alternative way, to profit from the volatility of all of the PP assets, be to tweak the rebalance bands of each so that LTT, gold and stocks all hit rebalance bands with equal frequency. Each would be sized up relative to the cash. So perhaps LTT would be kept between 0.95-1.05 (relative to cash being 1), stocks 0.9-1.1 and gold 0.85-1.15 or whatever. That way the basic core assets would still be held around 25:25:25:25 with all the "black swan robustness" advantages that gives.

[stone]

Clive, don't you think it is important to also bear in mind the volatility as seen from a currency that you might need to move to or buy stuff from? Gold may swing around a lot in GBP terms but trimming the gold may make the GBP based PP less robust when converted into USD, Euros, Yen or whatever. If things get really bad, that might be what counts the most. For me, I can imagine that the worst possible economic circumstances would be the time when having savings would become worthwhile.  It was gold that saved the Icelandic PP. I presume a Serbian PP ?!? would be an even more dramatic example.

[stone]

Clive, have you back tested the leveraged PP over the long term with real data? In your link you explain the logic of the leveraged PP based on price movements following brownian motion. My problem with that is that price movements don't follow brownian motion and that the basis of the PP is that they do not. I'm willing to believe that prices do jitter about in a way that is more brownian than many people appreciate but I think reality is a lot less brownian than it would need to be in order to cause the square rule benefit of leveraging up that you describe. As you say, if prices followed brownian motion (ie whether the price goes up or down is not infuenced by what the price is or whether it has just gone up or down) then the PP would in effect be a martingale betting strategy where the distribution of wins and losses was simply shifted by the strategy such that there were frequent small wins and occasional castastrophic losses with no long term benefit. In reality gold, stocks and LTT do not act randomly with respect to each other. A down year for all three together happens less frequently than would be predicted by chance alone (please correct me if I'm wrong). Also prices are influenced by the real economy/central bank etc such that bull and bear markets are genuine empirical facts and not some figment of the gambler's imagination as would be the case if prices followed brownian motion. An extensive survey showed that after a price had a down month, it was more likely to have a subsequent down month than brownian motion would predict ("beware of falling knives" effect). Conversely over a time span of decades, it is important to "buy low". The PP with 15%-35% catches both effects. It isn't clear to me that the leveraged PP wouldn't screw up against those realities.

I also think part of what makes the PP work is that it exploits the mispricing that comes from herd mentality. So be really careful about flitting between which asset to over-weight or under-weight in the "new improved" PP. A few months ago when 50year gilts cost 92p; you were pondering whether it might be better to ditch LTT altogether. Now they are 107p or whatever; you are pondering whether to over-weight them .

I also find it a struggle to follow the PP. I prematurely rebalanced when gold got to $1885 because I got spooked by the pace of increase. I hope that premature rebalancing is the least harmful form of deviance but I suppose in a total currency meltdown it might be the worst. In principle I agree with you that a major economy such as USA, Japan, Germany or UK is unlikely to have an Iceland style hiatus (or worse) but I don't think it is impossible.

[stone]

Clive, if you want to increase rebalancing frequency there is always the option of tightening the bands on a non-leveraged PP (say to 22%-28% or whatever). Wouldn't doing that and cutting down the cash portion on a non-leveraged PP be the same as increasing the cash and having leveraged etfs? In the recent period of jitteryness, there have been many inflection points and that has benefited frequent rebalancing. I thought the 15%-35% bands were chosen so as to avoid multiple rebalancing events during the course of rarer very large swings. So in Iceland 2008 it was better not to rebalance out of gold repeatedly. Perhaps a >80%  crash in stocks or gold might happen next year or whatever. If so; it would be better to have as few rebalancing events into stocks/gold on the way down as possible so as to preserve reserves for a big rebalancing near the bottom. I guess it is a tradeoff between harvesting as much as possible from jittery goofymarket nonsense versus from "big events". The PP is about permanence and so is skewed towards surviving "big events" hence the wide rebalancing bands. Am I in a muddle about this?

[clacy]

Very interesting discussion going on here.

I tend to like the 2x version of the HBPP, because as Clive points out, because of the greater volatility, you're going to have more re-balances, but you still get the overall smoothness of having the 4 key asset classes represented.

I am not running a leveraged PP, but have thought about it in the past.  If you put together a portfolio with 50% cash and the other half divided between 2x gold, 2x spy and 3x LTT's is sounding appealing.

With such a portfolio, your max loss would be 50% (pretty much the entire civilized world would have to melt down to induce that scenario).  And that is still much safer than the stock market, yet could easily produce significantly greater rewards and very likely fairly smooth volatility.

[MediumTex]

Clacy,

Make sure you understand the "decay" issue with all of these leveraged ETFs.

They are not long term investments.

[clacy]

Clacy,

Make sure you understand the "decay" issue with all of these leveraged ETFs.

They are not long term investments.

Yes, I understand decay and this is the main concern frankly.  However, decay doesn't appear to be as significant as I once thought (at least for SSO, UGL, TBT).  Also, you could withstand a certain level of decay if the returns were large enough due to the extra re-bal factor.

The biggest problem with a leveraged PP would be the fact that there is little in the way of testing that can be done for levered ETF's.

[stone]

Clive, that whole point of view rests on viewing cash as being somehow "other" than all alternative stores of value. I've seen cash described as "the purest from of speculation". There is nothing to cash apart from the belief that someone will swap it for something else in the future. I just think that it is important to see cash for what it is and not imagine that it has unworldly powers. I think that what matters is viewing the "risk" as being the potential downside of the entire portfolio in terms of real day to day costs. Quite possibly we are in a secular bear market for developed economy currencies. Cash might be the most hazardous part of the PP at the moment. It certainly was for developing country economies for the 1980s and 1990s.
In principle you could recalibrate all the values for the PP assets in terms of gold such that gold always had zero volatility and cash had great volatility. If you look at cash through that looking glass it becomes harder to want so much of it. Perhaps, I'm just laboring under a "grass is greener on the other side" sentiment because my better half has put so much of our savings in cash. I also just put £15k into ILSC .

[stone]

Clive, I have my doubts about how well ILSC really do keep pace with real inflation. Think of real possible costs. Have a basket of say a university education, health insurance, cost of emigrating to Singapore or where-ever -and think what has happened over the past  decade. The denominator of the cost of university education is zero as it used to be free. The cost of health insurance is still free but for how much longer? Did the cost of university education find its way into the RPI? I think cash needs to be seen with some circumspection just like all the other assets.

[stone]

Clive, the only way I can rationalize it is as an arbitrage on the different "cash" types available to you as a retail saver and the bank concocting the 3xETF. You can get RPI+0.5% as a ILSC depositor whilst the TBTF bank can borrow at 0.25% or whatever. Basically your scheme is a way to maximize your holdings of the market beating (in terms of return/risk/liquidity) ILSC whilst still getting exposure to the volatility of stocks,LTT and gold. I guess if ILSC could be traded and held in unlimited amounts, then they would trade much above par value. Otherwise banks would borrow at 0.5% to buy ILSC and get RPI+0.5% in return. Trillions of £ would be held in ILSC if they were not only available to individual people with a £15k per issue ration.

I guess if short term rates get cranked much above inflation, then leveraged ETFs might get withdrawn but perhaps that wouldn't harm you too much.

[Wonk]

2x PP Update:

The leveraged PP hit another rebalance band today.  This is only 2 months after the first rebalance.  This time, the 2x long bond is what hit the 35%, although the 2x equity portion was nearly at 15%.  All funds were rebalanced back to 25%.  Here are the numbers since inception:

1xPP: 25.19% (no rebalance yet)

2xPP: 57.19% (2 rebalancing events)

[stone]

Clive, I'm just being nosey but is this something you have done for real since 4th Jan or is it a hypothetical?

[Storm]

I admit I haven't followed this thread too closely, however, I'm very intrigued by the notion that perhaps the 2x or 3x leveraged PP can actually boost gains over a traditional 1x PP by hitting rebalance bands more often.  It seems that you might be able to counteract the decay effect these leveraged funds have by rebalancing multiple times a year.

For example, I never hit a LTT rebalance band in my PP (although I did buy stocks at a yearly low) so I missed out on some of the upside that the leveraged PP enjoyed.

Good work everyone.

I think even a fairly conservative investor could benefit by setting up their portfolio in such a way that 50-75% was traditional 1x PP and then take the remainder and do a 2x or 3x PP.  Why not juice returns by using the PP principals, while keeping the majority of your retirement in the traditional PP?  This could replace most VP speculation, as most people would be quite pleased with 20-30% annual gains in their VP.

[Wonk]

I think even a fairly conservative investor could benefit by setting up their portfolio in such a way that 50-75% was traditional 1x PP and then take the remainder and do a 2x or 3x PP.  Why not juice returns by using the PP principals, while keeping the majority of your retirement in the traditional PP?  This could replace most VP speculation, as most people would be quite pleased with 20-30% annual gains in their VP.

That was the original idea for me.  The concept that if a 2xPP would work, it would represent the prospect of 20%+ annual returns with average volatility and no work.  That made me ask the question: what is my target return for a VP for the associated risks and time involved?

I don't think a 2xPP can match the risk/reward that a start-up business venture can present, but otherwise the 2XPP offers the potential for a solid return compared to similar VP investments such as rental real estate and stock picking.  For instance, say someone likes the 4-5% real returns of the PP, but wants more potential for growth.  You could run an 80% PP and 20% VP consisting of 2xPP funds.  The blend would likely offer another 200bps to the annual return for a total real return of 6-7% with a mitigated downside risk.  I like that idea much better than trying to buy apartment houses and manage tenants.

I don't run a VP like this at the moment, but I wouldn't rule it out in the future.  So far I haven't seen any evidence of decay when viewed as a whole (over the last 21 months).  The primary concern for me in such a portfolio is counterparty risk in a systemic crisis.  On the other hand, counterparty risk might be dampened somewhat with a margin account through I.B. rather than 2x funds. 

[clacy]

I think even a fairly conservative investor could benefit by setting up their portfolio in such a way that 50-75% was traditional 1x PP and then take the remainder and do a 2x or 3x PP.  Why not juice returns by using the PP principals, while keeping the majority of your retirement in the traditional PP?  This could replace most VP speculation, as most people would be quite pleased with 20-30% annual gains in their VP.

That was the original idea for me.  The concept that if a 2xPP would work, it would represent the prospect of 20%+ annual returns with average volatility and no work.  That made me ask the question: what is my target return for a VP for the associated risks and time involved?

I don't think a 2xPP can match the risk/reward that a start-up business venture can present, but otherwise the 2XPP offers the potential for a solid return compared to similar VP investments such as rental real estate and stock picking.  For instance, say someone likes the 4-5% real returns of the PP, but wants more potential for growth.  You could run an 80% PP and 20% VP consisting of 2xPP funds.  The blend would likely offer another 200bps to the annual return for a total real return of 6-7% with a mitigated downside risk.  I like that idea much better than trying to buy apartment houses and manage tenants.

I don't run a VP like this at the moment, but I wouldn't rule it out in the future.  So far I haven't seen any evidence of decay when viewed as a whole (over the last 21 months).  The primary concern for me in such a portfolio is counterparty risk in a systemic crisis.  On the other hand, counterparty risk might be dampened somewhat with a margin account through I.B. rather than 2x funds. 

Look at a long term chart of SSO vs SPY dating back to SSO's inception.  You'll see the decay factor. 

Maybe decay can be counterbalanced because of volatility capture.  I'm not sure, but I do see decay when I look at leveraged returns.  The past 21 months has treated the 2x PP very well, but I certainly don't think it will always be like that.  I'm not an expert on the reasons for decay and how these 2/3x ETF's are operated, every leveraged fund that I've looked at with a 4+ year track record has under-performed their 1x counterparts in a big way.

I happen to think that futures might be the best way to leverage the PP.  Hedgefunds and so forth, usually turn to futures when they are looking for leverage. 

[Maestro G]

The SSO, SPY comparison looks about right to me Clacy.

2x leveraged funds look to provide twice the DAILY motions. Which means you both double the daily gains (or losses) and double the standard deviation (volatility).

A 0% yearly average with a 20% standard deviation will typically annualise to -2%
A 0% yearly average with a 40% standard deviation will typically annualise to a -8.3%

i.e. the higher volatility induces a lower annualised.

Countering that however are a number of factors. As prices rise so the 2x in effect scales up exposure, so you gain more over a period of time of rising markets (more than 2x the multiple days reward). As prices decline the 2x in effect scales down exposure so you lose less than 2x over a period of time of declining markets (lose less than 2x the multiple days losses).

Another factor is that you rebalance more, which cost averages down quicker so to speak.

i.e. the 'drag factor' is somewhat countered by running winners, cutting losers type adjustments and by the higher levels of better cost averaging (rebalancing more frequently).

The easiest way to perhaps think of it is that if you borrow to leverage, then typically you'll pay around the cash rate (which generally = inflation) for those borrowed funds. If the PP achieves a 4% real (after inflation) then the benefit of having borrowed to invest in a PP is 4%. If inflation (and cash) is 6% a normal PP might yield a 10% total, whilst a borrowed to invest PP might yield a 4% total gain. Combined that 2x = 10% (non borrowed based PP) + 4% (borrowed based PP) = 14%, compared to 10% for the 1x.

Whilst in nominal terms a 14% reward for a 2x compared to a 10% for a 1x isn't twice the reward, in real (after inflation) terms it is much closer.

10% for the 1x less 6% inflation = 4% real
14% for the 2x less 6% inflation = 8% real

and that doesn't include additional/faster cost averaging benefits (more frequent rebalance trading).

Individual 2x holdings do tend to zigzag around the 1x. Sometimes beating it by more than 2x, sometimes just pacing it, other times being down by approaching 2x. Blending a number of low correlated 2x's tends to smooth that out such that the set more closely paces the 2x performance overall.

It appears to me that the 2x PP, especially in view of the low correlations of the individual components, can work as desired.

A reasonable blend for a 2x like PP might be to hold 16% in BGU (3x stocks so like holding 48% stocks), 16% TMF (3x LTT so like holding 48% LTT), 24% UGL (2x gold so like holding 48% gold) and 44% cash. Year to date that's earned just over 25% and triggered 3 rebalance events. The 1x PP (without any rebalancing) year to date is up around 11%.

Whilst there might be greater third party risk from holding leveraged funds, if you used a 2x to emulate a 1x overall, then you might hold 8% BGU, 8% TMF, 12% UGL and 72% cash. In holding so much cash your risk against the leveraged funds is in effect a -28% maximum loss assuming all three leveraged funds went toes-up. Whilst that would be uncomfortable, its not critical. Little different to a conventional PP investor who perhaps held 25% in a gold ETF and who then saw that ETF fail.

If instead of holding 72% in cash, those funds are deployed into an alternative investment - perhaps a classic PP - that earned > cash then !!!

Clive,

The 72/28 ratio of very safe assets to extremely risky/volatile assets that you are suggesting reminds of the strategy that Nassim Taleb touts in his "Black Swan" tome, although his ratio is a little more conservative IIRC. Something like 90/10. Essentially another variation on the "Fat Tail" strategy, yes?

Maestro G

[clacy]

Clive, since you are in the UK I believe, why not spreadbet for leverage?  I don't know a lot about it, but besides the spread, is there any borrowing cost? 

I would suspect that counter-party risk might be a problem that would make this way of leveraging null and void, but I don't know how that works.