In this post, I describe a gentle alternative to HEDGEFUNDIE's 3x leveraged ETFs as described below. Of course, some of you will find that this approach is not gentle and a worse alternative... I welcome your (kind) input.
What am I trying to do?
I'd like an investment strategy with a risk profile similar to being 100% stocks with a higher expected return. Easy enough, eh?
I'm also young (33) and willing and able to take risk.
What is a 2-year Treasury Future?
A single 2-year treasury futures contract is the equivalent to the return of $200K worth of 2-year treasury notes minus the return of $200K worth of 3-month treasury bills. The return of the 3-month treasury bills is the effective interest rate that you are paying, which is really low ~2%. For no movement in future interest rates, the expected return of 2-year treasury futures would be the spread in the 3-mo and 2-year interest rates. [Note that right now that spread is negative due to the yield curve inversion, but the a key benefit of holding treasury futures, as described below, is that it limits the overall portfolio drawdowns in bad years.]
66% Total US Stock Market
29% Total International Stock Market
5% cash, held to meet margin requirements for futures
285% 2-year Treasury Futures (\ZT)
385% sum (3.8x leverage)
That's a crazy amount of leverage!
Yes, it's technically 3.8x leverage, BUT this is NOT the same as a leveraged equity portfolio. The max year-to-year drawdown for 2-year treasury futures has been 6.8% since in 1980 (calculated from Simba's spreadsheet). 2-year treasuries are relatively safe and have limited price fluctuations. Their limited price fluctuations are in fact the reason why a large amount of leverage is needed to counteract volatility due to equities in the portfolio.
Why would I do this? (i.e. leveraging is DANGEROUS!)
Historically, 2-Year Treasuries have weak and (for some periods) strongly negative correlation with the US stock market. This weak to negative correlation reduces the overall standard deviation of the portfolio while giving a bump in the expected annual returns (since their expected return is positive).
A Portfolio Comparison by the Numbers
When backtested from 1980 to 2018 using Simba's spreadsheet with yearly rebalancing (available through the Boglehead wiki), we get the following. ---> Of course these numbers will change over different backtesting periods. This is just a representative example. <--
[It goes without saying that the past is not a predictor of the future and that interest rates today are much lower than they were in 1980s.]
Proposed Portfolio vs 100% Total Stock Market Portfolio (1980-2018, Simba spreadsheet)
14.7% vs 11.1% compound annual growth rate (CAGR)
18.2% vs. 16.6% std. deviation
24% vs 37% max drawdown
0.65 vs 0.48 Sharpe ratio
2.64 vs 1.28 Sortino ratio
0.84 vs 1 US Mkt correlation
0.70 vs 0.68 Intl Mkt correlation
(these numbers are calculated on a year-to-year basis, due to limitations of the backtesting spreadsheet)
Proposed Portfolio vs 100% S&P500 (1997-2019, Portfolio Visualizer)
Link to portfolios in Portfolio Visualizer (limited to 1997 due to Total Intl Stock Market dataset)
Looking at these plots, it seems that the greatest benefit of the 2-year treasury futures is limiting the drawdown in bad years. From this perspective, adding leverage with 2-year treasury futures LOWERS overall risk, at least compared to an all-stock portfolio.
Advantages Compared to 3x ETFs
- no leverage in equities so a large stock market drop won't "wipe out" a stock position
- no large ~1% expense ratio charged by 3x ETFs
- no volatility decay (so that my portfolio performance matches that of the underlying assets)
- minimum capital required for 2-year treasury futures (~$700 margin requirement buys $200K worth of 2-year treasury exposure)
- futures are tax efficient — income taxed at 60% long-term capital gains + 40% short-term capital gains. Note that typical bond income is taxed as ordinary income (i.e. 100% short-term gains).
- initial burden of setting up a futures trading account
- despite low margin requirements, you need to keep extra cash available to handle the daily mark-to-market adjustments as the futures prices move up or down (if you don't keep a large amount of cash on hand, then you may be subject to a margin call if treasuries fall in price)
- need to roll treasury futures every 3 months
- scare factor of leverage
Overall, I wanted to present this to the community and seek comments and feedback. Overall, I believe that the proposed portfolio is advantageous compared to a 100% stock portfolio, and for those seeking less risk, simply drop the equity and futures exposure and you should still get better risk-adjusted returns compared to a similar portfolio without futures.
--> Now cue the first comment about how Bogleheads don't invest in futures or use leverage!