Edit: For more clarity - risk parity can make sense, but I don't think you ever need to use leverage on your equities to get risk parity. The fundamental insight of risk parity investing is that at commonly recommended ratios (50/50, 60/40) the risk (variance) from equities totally dominates the risk from bonds. So the risk parity advice is usually something with a much higher bond mix, but the entire portfolio is leveraged. But DO NOT use levered ETFs that recognize, say, 3x the DAILY movement of the S&P to do this. They don't do what you think. Read that link, or compute the following two scenarios:
1) Market goes up 1.1% on odd days, down 1% on even days. That yields about 9% (200 trading days). But a 3x daily etf product would only get you about 22%, not 27%.
2) Market foes up 1% on odd days, down 1.1% on even. That, sadly, means you lose about 11% on the year. If you use a 3x DAILY etf product, you lose around 75%.
Please read the write-up before replying with blanket statements that aren't relevant in this case :)
That issue is addressed in the bogleheads post explicitly ("How much does the leverage cost?" and "Don't you know that leveraged ETFs are only intended to be held for one day?"), basically the ETFs are risk parity adjusted, and the volatility in the ETFs actually what generates the returns. The strategy makes money from volatility, and the 3X leverage is used to add volatility in, exaggerating the returns.
I think you might find the post interesting because it seems like you are interested in investing. What you're saying is again explicitly addressed there, and factored into the calculation. They work an example of that kind of decay, and how it's mitigated. Specifically, it doesn't matter that you have volatility decay in one of the ETFs because they're uncorrelated, and when one goes up the other goes down, canceling out the effect.
Your blanket statement does not apply to this specific strategy. It's not wrong in general, but it's not relevant here.
If you don't want to read the bogleheads write-up it's also addressed on Seeking Alpha [1].
> "That, sadly, means you lose about 11% on the year."
Not if, as you see in the write-up, you pair it with an uncorrelated 3X leveraged asset and rebalance periodically.
I've been using 3x ETFs for the past few years to pursue a Permanent Portfolio style strategy in one account, and an All Weather strategy in another, rebalance annually, and both have been doing well.
Low net volatility, high returns. Backtesting of the strategy shows total returns just under 3x the return of the unleveraged portfolios, just what I expect given the leverage costs.
I expect both strategies to be both market-agnostic and age-agnostic. About as close to fire and forget as you can get.
That’s true in general, but this strategy is basically set it and forget it (rebalance quarterly for best results), and it works because it’s been carefully balanced to offset decay.
It's all in the post ("Don't you know that leveraged ETFs are only intended to be held for one day?" section) but there's something we need to clear up before we start.
(1) What people refer to as "decay" is just the way the the daily exposure works on these ETFs. To quote the article:
"Let's say over five days the daily returns of the index are +1%, -2%, +3%, -4%, +5%, and you start with $100."
"At the end of the five days your $100.00 becomes $102.76."
"Now let's use a 3X leveraged ETF. Ignoring ER and other costs, the daily returns are +3%, -6%, +9%, -12%, +15%."
"At the end of the five days your $100.00 becomes $106.80."
6.80 is not 3X 2.76, and it's because down days leave you with less exposure the following day, so you need a bigger up day than the preceding down day to make up for it. However, as the article points out, this dynamic works for you in ETFs that exhibit positive momentum. Since "stocks always go up" -- at least the S&P always goes up over time, so far -- this dynamic works to your favor and the total return of UPRO to date has been 5X the return of SPY.
(2) UPRO and TMF are uncorrelated, and so the positive momentum of SPY causes UPRO performance to exceed 3X, and offset some of the lower-than-3X performance of TMF over time. For the record since 2017, the performance of TMF is 2X that of TLT, give or take.
(3) Further, the way this makes money is actually when the S&P drops 10%, UPRO drops 30%. As people flee assets, they buy treasuries, pushing TLT up 6-7%, which causes TMF to go up 20%. Then at rebalancing time, you sell TMF and use it to buy UPRO, so you sell the 3X winner, and buy the 3X loser at a deflated price. When prices normalize, the extra shares on the losing end in conjunction with positive momentum (and the fact you've reduced the size of your winner before it falls) put you much further ahead than if you weren't using leveraged ETFs.
This strategy makes money on volatility, and should be agnostic to market performance. It actually held up really well during March.
Part of what I do is something I'll call "pile of reserve" investing. I'll hold like $X in some leveraged fund but I have 50x in cash on the side so if things go south I can dollar average my way to profitability. This also requires constantly winnowing down profitable investments to insulate from risk. I've been doing this for about 3 years. About a 3x return on my current holdings, which is about 50% of the maximum I've had in.
This will very likely make less money but really, I can pay all my (admittedly very modest) bills with my portfolio and have returns left over + my actual day job income so honestly, why do I care?
I come from a privileged background and I lived that life. I didn't like it and have no interest in returning to it.
People have to find the strategy and mix that works for them.
I like the strategy and employ it on a portion of my 401k. I think you need to do it in a tax-advantaged account, otherwise rebalancing + short term gains will eat away your profits.
Also, that strategy fails in a rising interest rates environment like in the 50s and 60s (not sure of exact years). Fed has indicated keeping rates low for the next two years, but if they start hiking rates after, I think the strategy would underperform.
You are probably better off doing this in a tax advantaged account, or if you have a large lump sum you want to invest you can do the rebalancing by adding money over time instead of selling the winner and redistributing it to the loser.
The strategy would fail if both interest rates went up and equities went down or stayed flat. While the potential exists for an underperform condition there in a couple of years I personally suspect the fed won’t raise rates unless equities are performing spectacularly. I’m quite skeptical if their 2 year time frame, even to say we may be looking at the new normal.
I appreciate your measured response. I certainly had not dug deep into these daily 3X funds, as the daily/drag aspect seemed (seems?) clearly a problem. But, I can't just pretend the 10yr history of UPRO doesn't exist. I'll have to think more about this.
If it were possible (I recognize it isn't, due to margin limits), would it not be better to be 3x leveraged in your margin account, and simply buy the basic S&P and bond products? Wouldn't that avoid the "drag", and you'd end up better off?
https://capitalallocatorspodcast.com/wp-content/uploads/2017...
Edit: For more clarity - risk parity can make sense, but I don't think you ever need to use leverage on your equities to get risk parity. The fundamental insight of risk parity investing is that at commonly recommended ratios (50/50, 60/40) the risk (variance) from equities totally dominates the risk from bonds. So the risk parity advice is usually something with a much higher bond mix, but the entire portfolio is leveraged. But DO NOT use levered ETFs that recognize, say, 3x the DAILY movement of the S&P to do this. They don't do what you think. Read that link, or compute the following two scenarios:
1) Market goes up 1.1% on odd days, down 1% on even days. That yields about 9% (200 trading days). But a 3x daily etf product would only get you about 22%, not 27%.
2) Market foes up 1% on odd days, down 1.1% on even. That, sadly, means you lose about 11% on the year. If you use a 3x DAILY etf product, you lose around 75%.