The prototypical example at the time was a 1.5x levered 60% stock / 40% bond portfolio (also referred to as a “90/60”). Such a portfolio would allow investors to achieve the exposure of a 60/40 using just two-thirds of their capital, freeing up valuable portfolio real estate for diversifying alternatives.
Implementing such a portfolio in practice was also trivial: for every $1 invested, $0.9 could be invested in stocks and $0.1 held aside as cash collateral for a $0.6 notional position in U.S. Treasury futures.
Figure 1: One Possible Implementation of a 90/60 Portfolio
Today, the 13-week Treasury Bill rate hovers near 4.5% and the yield curve is severely inverted, causing many to ask, “does return stackingTM still make sense, particularly if we use Treasury futures to achieve our leverage?”
We believe the answer is a resounding “yes,” with four key points to consider.
It’s the portfolio, not the asset
With the yield curve severely inverted, paying short-term financing costs to invest in long-term Treasuries to achieve our leverage may seem like a losing prospect. We believe this line of thinking is misguided, however; it misses the forest for the trees.
Using U.S. Treasury futures is simply a means to an end. Sticking with our 90/60 example, what we actually care about is achieving 1.5x levered 60/40 exposure and the flexibility that creates for us in portfolio construction.
Would we have the same concern about an inverted yield curve if for every $1 invested we purchased $0.6 of U.S. Treasuries and held $0.4 in cash as collateral for $0.9 in S&P 500 futures exposure? What if we simply borrowed money to lever an entire 60/40 portfolio up 1.5x?
Figure 2 plots that the annual returns of these three different approaches. We can see that they are nearly identical to one another.
Figure 2: Annual Returns for Varying Approaches to Implementing a Levered 60/40 Portfolio
Source: Tiingo, Bloomberg, Barcharts. Calculations by Newfound Research. Past performance is backtested and hypothetical. Returns are gross of all fees, costs, and taxes except for underlying expense ratios. Returns assume the reinvestment of all distributions. Past performance is not indicative of future results. Starting date based upon the availability of pricing data.
To draw this point out further, consider the case of explicitly borrowing money to lever the 60/40 portfolio up 1.5x and the following ways we could implement this portfolio:
Hold 90% in stocks, 10% in U.S. Treasuries, and borrow to buy another 50% in U.S. Treasuries;
Hold 60% in U.S. Treasuries, 40% in stocks, and borrow to buy another 50% in stocks;
Hold 60% in stocks, 40% in U.S. Treasuries, and borrow to buy another 30% in stocks and 20% in U.S. Treasuries.
Figure 3: Different Approaches to Creating a 90/60 Portfolio
Does it matter which we choose? Does an inverted yield curve make the first choice less attractive than the second?
In theory, we should be indifferent to these choices. If we are concerned about using U.S. Treasury futures to achieve a levered 60/40, we should be equally concerned about using equity futures (“invert, always invert!”),
Sourcing cheap leverage.
In practice, we do care how we implement a return stackedTM portfolio. Not because the yield curve is inverted, but because explicitly borrowing at the short-term Treasury Bill rate is difficult for all but the largest institutions.
Treasury futures have historically allowed us to do just that, giving us a very cost-effective source of leverage. Figure 4 plots the embedded cost of leverage in 10-Year U.S. Treasury Futures relative to 3-Month U.S. Treasury Bill rates. By contrast, at the time of this writing, the current base margin rate is 10.75% at Schwab, 11.33% at Fidelity, and 12.50% at TD Ameritrade.
Figure 4: Embedded Financing Cost in 10-Year U.S. Treasury Futures versus 3-Month U.S. Treasury Bill Rate
Source: Bloomberg.
It’s the excess returns that matter.
But what about the fact that short-term rates have climbed from near-zero to north of 4%. Is leverage now unattractive because the cost of financing is so high?
Let us return, for a moment, back to basic portfolio theory which says the expected return of an asset can be decomposed into two parts: the risk-free rate and the asset’s risk premium. For example, the expected return of stocks should be equal to the risk-free rate plus the equity risk premium (“ERP”). Similarly, the expected return of bonds should be equal to the risk-free rate plus the bond risk premium (“BRP”).
Figure 5: Decomposing Expected Returns into the Risk-Free Rate and Risk Premia
The expected return of a portfolio, then, can simply be thought of as the risk-free rate plus the blended return of risk premia. For example, the expected return of a 60/40 is:
What about a 45% Stock / 30% Bond / 25% Cash portfolio? No surprise:
30% ERP + 20% BRP + 100% Risk-Free Rate
= 0.5x (60% ERP + 40% BRP) + 100% Risk-Free Rate
Whether we’re holding cash, fully invested, or levered, all we are doing is scaling the risk premium exposure! It is the returns in excess of the risk-free rate that matter.
The important implication here is that if we believe the levered portfolio is unattractive to invest in, it must also mean we believe the unlevered portfolio is unattractive to invest in.1 If 60% ERP + 40% BRP is negative, no amount of scaling up or down will change it; we’d be better off just holding cash.
The null hypothesis is that markets are efficient.
None of this negates the fact that an investor may hold the active view that intermediate- to long-term U.S. Treasuries are unattractive to hold relative to cash today. Such a view, however, is not unique to a levered portfolio: it would affect levered and unlevered portfolios alike. To remain consistent with such a view, an investor should sell down their long-duration bonds in preference for short-duration exposure, regardless of leverage.
The only point we will stress here is that we believe the prudent approach is to assume, as a null hypothesis, that markets are generally efficient. After all, if everyone held the same active view that long duration bonds are currently unattractive, they would sell those bonds, driving up the yield until the point they are attractive. If we believe markets are generally in equilibrium, the current long-term yield should be equally attractive as the short yield when appropriately adjusted for their risks.
How can that be the case when the short-term rate is higher than the long-term rate? The pure expectations hypothesis states that the yield curve embeds the expected path of short rates. It is important to remember that the expected return of a longer-dated Treasury should be compared to the expected return of a constantly rolled shorter-dated Treasury. An inverted yield curve, then, expresses the aggregate view that short rates should be lower in the future, which would bring down the return of the constantly rolled short-rate series.
Nevertheless, if an investor does have an active view about the relative expected returns of short- versus longer-dated Treasuries, that view would be expressed regardless of whether the portfolio is levered or not.
Conclusion
In this note we have attempted to address the question as to whether return stackingTM still makes sense when the cost of financing goes up, particularly if we’re accessing that financing through longer-dated Treasury futures during an inverted yield curve environment.
We believe the answer is ‘yes’, and four key points help illustrate this fact. First, philosophically, we care less about the specific asset we are levering than the make-up of the levered portfolio. Second, in practice we want to choose an asset to lever that provides us with a cost of financing as close to the risk-free rate as possible. Third, it is the return in excess of the risk-free rate that ultimately matters. Finally, an active view about the relative attractiveness of Treasuries applies regardless of whether the portfolio is levered or not.
As a final point, we want to zoom out once more to emphasize the portfolio view. Consider the investor who uses a 90/60 portfolio to free up capital, and that freed up capital is invested for alpha exposure. Very frequently, alpha exposures are packaged in a way they provide cash plus alpha returns. For example, a managed futures fund is effectively U.S. T-Bills plus the return of an active futures trading strategy.
Which means the cash positions effectively net out. Assume we put 66.6% of our portfolio in a 90/60 and 33.3% of our portfolio in a managed futures fund. If we x-ray the former position, we effectively have 60% stocks plus 40% bonds minus 33.3% U.S. T-Bills. If we x-ray the latter, we effectively have 33.3% T-Bills plus 33.3% of the active futures strategy. Taken together, we’re left with 60% stocks plus 40% bonds plus 33.3% of the active futures strategy.
More than anything, it’s the net portfolio allocation that matters.
A long/flat tactical equity strategy with a portable beta bond overlay – a tactical 90/60 portfolio – has many moving parts that can make attribution and analysis difficult.
By decomposing the strategy into its passive holdings (a 50/50 stock/bond portfolio and U.S. Treasury futures) and active long/short overlays (trend equity, bond carry, bond momentum, and bond value), we can explore the historical performance of each component and diversification benefits across each piece of the strategy.
Using a mean-variance framework, we are also able to construct an efficient frontier of the strategy components and assess the differences between the optimal portfolio and the tactical 90/60.
We find that the tactical 90/60 is relatively close to the optimal portfolio for its volatility level and that its drawdown risk profile is close to that of an unlevered 60/40 portfolio.
By utilizing a modest amount of leverage and pairing it will risk management in both equities and bonds, investors may be able to pursue capital efficiency and maximize portfolio returns while simultaneously managing risk.
Portable beta strategies seek to enhance returns by overlaying an existing portfolio strategy with complementary exposure to diversifying asset classes and strategies. In overlaying exposure on an existing portfolio strategy, portable beta strategies seek to make every invested dollar work harder. This idea can create “capital efficiency” for investors, freeing up dollars in an investor’s portfolio to invest in other asset classes or investment opportunities.
At Newfound, we focus on managing risk. Trend following – or absolute momentum – is a key approach we employ do this, especially in equities. Trend equity strategies are a class of strategies that aim to harvest the long-term benefits of the equity risk premium while managing downside risk through the application of trend following.
We wrote previously how a trend equity strategy can be decomposed into passive and active components in order to isolate different contributors to performance. There is more than one way to do this, but in the most symmetric formulation, a “long/flat” trend equity strategy (one that that either holds equities or cash; i.e. does not short equities) can be thought of as a 100% passive allocation to a 50/50 portfolio of stocks and cash plus a 50% overlay allocation to a long/short trend equity strategy that can move between fully short and fully long equities. This overlay component is portable beta.
We have also written previously about how a portable beta overlay of bonds can be beneficial to trend equity strategies – or even passive equity investments, for that matter. For example, 95% of a portfolio could be invested in a trend equity strategy, and the remaining 5% could be set aside as collateral to initiate a 60% overlay to 10-year U.S. Treasury futures. This approximates a 60/40 portfolio that is leveraged by 50%
Source: Newfound. Allocations are hypothetical and for illustrative purposes only.
Since this bond investment introduces interest rate risk, we have proposed ways to manage risk in this specific sleeve using factors such as value, carry, and momentum. By treating these factors as fully tactical long/short portfolios themselves, if we hold them in equal weight, we can also break down the tactical U.S. Treasury futures overlay into active and passive components, with a 30% passive position in U.S. Treasury futures and 10% in each of the factor-based strategies.
Source: Newfound. Allocations are hypothetical and for illustrative purposes only.
When each overlay is fully invested, the portfolio will hold 95% stocks, 5% cash, and 60% U.S. Treasury futures. When all the overlays are fully short, the strategy will be fully invested in cash with no bond overlay position.
While the strategy has not changed at all with this slicing and dicing, we now have a framework to explore the historical contributions of the active and passive components and the potential diversification benefits that they offer.
Diversification Among Components
For the passive portfolio 50/50 stock/cash, we will use a blend of the Vanguard Total U.S. stock market ETF (VTI) and the iShares Short-term Treasury Bond ETF (SHV) with Kenneth French data for market returns and the risk-free rate prior to ETF inception.
The passive 10-year U.S. Treasury futures is the continuous futures contract with a proxy of the 10-year constant maturity Treasury index minus the cash index used before inception (January 2000). The active long/short bond factors can be found on the U.S. Treasuries section of our quantitative signals dashboard, which is updated frequently.
All data starts at the common inception point in May 1957.
As a technical side note, we must acknowledge that a constant maturity 10-year U.S. Treasury index minus a cash index will not precisely match the returns of 10-year U.S. Treasury futures. The specification of the futures contracts state that the seller of such a contract has the right to deliver any U.S. Treasury bond with maturity between 6.5 and 10 years. In other words, buyers of this contract are implicitly selling an option, knowing that the seller of the contract will likely choose the cheapest bond to deliver upon maturity (referred to as the “cheapest to deliver”). Based upon the specification and current interest rate levels, that current cheapest to deliver bond tends to have a maturity of 6.5 years.
This has a few implications. First, when you buy U.S. Treasury futures, you are selling optionality. Finance 101 will teach you that optionality has value, and therefore you would expect to earn some premium for selling it. Second, the duration profile between our proxy index and 10-year U.S. Treasury futures has meaningfully diverged in the recent decade. Finally, the roll yield harvested by the index and the futures will also diverge, which can have a non-trivial impact upon returns.
Nevertheless, we believe that for the purposes of this study, the proxy index is sufficient for broad, directional attribution and understanding.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
The 50/50 Stock/Cash portfolio is the only long-only holding. While the returns are lower for all the other strategies, we must keep in mind that they are all overlays that can add to the 50/50 portfolio rather than simply de-risk and cannibalize its return.
This is especially true since these overlay strategies have exhibited low correlation to the 50/50 portfolio.
The table below shows the full period correlation of monthly returns for all the portfolio components. The equity and bond sub-correlation matrices are outlined to highlight the internal diversification.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Not only do all of the overlays have low correlation to the 50/50 portfolio, but they generally exhibit low cross-correlations. Of the overlays, the L/S bond carry and L/S bond momentum strategies have the highest correlation (0.57), and the L/S bond carry and passive bond overlay have the next highest correlation (0.47).
The bond strategies have also exhibited low correlation to the equity strategies. This results in good performance, both absolute and risk-adjusted, relative to a benchmark 60/40 portfolio and a benchmark passive 90/60 portfolio.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Finding the Optimal Blend
Up to this point, we have only considered the fixed allocations to each of the active and passive strategies outlined at the beginning. But these may not be the optimal holdings.
Using a block-bootstrap method to simulate returns, we can utilize mean-variance optimization to determine the optimal portfolios for given volatility levels.1 This yields a resampled historical realized efficient frontier.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Plotting the benchmark 60/40, benchmark 90/60, and the tactical 90/60 on this efficient frontier, we see that the tactical 90/60 lies very close to the frontier at about 11.5% volatility. The allocations for the frontier are shown below.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
As expected, the lower volatility portfolios hold more cash and the high volatility portfolios hold more equity. For the 9% volatility level, these two allocations match, leading to the full allocation to a 50/50 stock/cash blend as in the tactical 90/60.
The passive allocation to the Treasury futures peaks at about 60%, while the L/S bond factor allocations are generally between 5% and 20% with more emphasis on Value and typically equal emphasis on Carry and Momentum.
The allocations in the point along the efficient frontier that matches the tactical 90/60 portfolio’s volatility are shown below.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
In this portfolio, we see a higher allocation to passive equities, a smaller position in the tactical equity L/S, and a larger position in passive Treasury futures. However, given the resampled nature of the process, these allocations are not wildly far away from the tactical 90/60.
The differences in the allocations are borne out in the Ulcer Index risk metric, which quantifies the severity and duration of drawdowns.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
The efficient frontier portfolio has a lower Ulcer Index than that of the tactical 90/60 even though their returns and volatility are similar. However, the Ulcer index of the tactical 90/60 is very close to that of the benchmark 60/40.
These differences are likely due to the larger allocation to the tactical equity long/short which can experience whipsaws (e.g. in October 1987), the lower allocation to passive U.S. equities, and the lower allocation to the Treasury overlay.
In an uncertain future, there can be significant risk in relying too much on the past, but having this framework can be useful for gaining a deeper understanding of which market environments benefit or hurt each component within the portfolio and how they diversify each other when held together.
Conclusion
In this research note, we explored diversification in a long/flat tactical equity strategy with a portable beta bond overlay. By decomposing the strategy into its passive holdings (50/50 stock/bond portfolio and U.S. Treasury futures) and active long/short overlays (trend equity, bond carry, bond momentum, and bond value), we found that each of the overlays has historically exhibited low correlation to the passive portfolios and low cross-correlations to each other. Combining all of these strategies using a tactical 90/60 portfolio has led to strong performance on both an absolute and risk-adjusted basis.
Using these strategy components, we constructed an efficient frontier of portfolios and also found that the “intuitive” tactical 90/60 portfolio that we have used in much of our portable beta research is close to the optimal portfolio for its volatility level. While this does not guarantee that this portfolio will be optimal over any given time period, it does provide evidence for the robustness of the multi-factor risk-managed approach.
Utilizing portable beta strategies can be an effective way for investors to pursue capital efficiency and maximize portfolio returns while simultaneously managing risk. While leverage can introduce risks of its own, relying on diversification and robust risk-management methods (e.g. trend following) can mitigate the risk of large losses.
The fear of using leverage and derivatives may be an uphill battle for investors, and there are a few operational burdens to overcome, but when used appropriately, these tools can make portfolios work harder and lead to more flexibility for allocating to additional opportunities.
If you are interested in learning how Newfound applies the concepts of tactical portable beta to its mandates, please reach out (info@thinknewfound.com).
In this commentary, we revisit the idea of portable beta: utilizing leverage to overlay traditional risk premia on existing strategic allocations.
While a 1.5x levered 60/40 portfolio has historically out-performed an all equity blend with similar risk levels, it can suffer through prolonged periods of under-performance.
Positive correlations between stocks and bonds, inverted yield curves, and rising interest rate environments can make simply adding bond exposure on top of equity exposure a non-trivial pursuit.
We rely on prior research to introduce a tactical 90/60 model, which uses trend signals to govern equity exposure and value, momentum, and carry signals to govern bond exposure.
We find that such a model has historically exhibited returns in-line with equities with significantly lower maximum drawdown.
In November 2017, I was invited to participate in a Bloomberg roundtable discussion with Barry Ritholtz, Dave Nadig, and Ben Fulton about the future of ETFs. I was quoted as saying,
Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations. The innovation needs to be around efficient use of capital. Instead of an ETF that holds intermediate-term Treasuries, I would like to see a U.S. Treasury ETF that uses Treasuries as collateral to buy S&P 500 futures, so you end up getting both stock and bond exposure. By introducing a modest amount of leverage, you can take $1 and trade it as if the investor has $1.50. After 2008, people became skittish around derivatives, shorting, and leverage. But these aren’t bad things when used appropriately.
Shortly after the publication of the discussion, we penned a research commentary titled Portable Beta which extolled the potential virtues of employing prudent leverage to better exploit diversification opportunities. For investors seeking to enhance returns, increasing beta exposure may be a more reliable approach than the pursuit of alpha.
In August 2018, WisdomTree introduced the 90/60 U.S. Balanced Fund (ticker: NTSX), which blends core equity exposure with a U.S. Treasury futures ladder to create the equivalent of a 1.5x levered 60/40 portfolio. On March 27, 2019, NTSX was awarded ETF.com’s Most Innovative New ETF of 2018.
The idea of portable beta was not even remotely uniquely ours. Two anonymous Twitter users – “Jake” (@EconomPic) and “Unrelated Nonsense” (@Nonrelatedsense) – had discussed the idea several times prior to my round-table in 2017. They argued that such a product could be useful to free up space in a portfolio for alpha-generating ideas. For example, an investor could hold 66.6% of their wealth in a 90/60 portfolio and use the other 33.3% of their portfolio for alpha ideas. While the leverage is technically applied to the 60/40, the net effect would be a 60/40 portfolio with a set of alpha ideas overlaid on the portfolio. Portable beta becomes portable alpha.
Even then, the idea was not new. After NTSX launched, Cliff Asness, co-founder and principal of AQR Capital Management, commented on Twitter that even though he had a “22-year head start,” WisdomTree had beat him to launching a fund. In the tweet, he linked to an article he wrote in 1996, titled Why Not 100% Equities, wherein Cliff demonstrated that from 1926 to 1993 a 60/40 portfolio levered to the same volatility as equities achieved an excess return of 0.8% annualized above U.S. equities. Interestingly, the appropriate amount of leverage utilized to match equities was 155%, almost perfectly matching the 90/60 concept.
Source: Asness, Cliff. Why Not 100% Equities. Journal of Portfolio Management, Winter 1996, Volume 22 Number 2.
Following up on Cliff’s Tweet, Jeremy Schwartz from WisdomTree extended the research out-of-sample, covering the quarter century that followed Cliff’s initial publishing date. Over the subsequent 25 years, Jeremy found that a levered 60/40 outperformed U.S. equities by 2.6% annualized.
NTSX is not the first product to try to exploit the idea of diversification and leverage. These ideas have been the backbone of managed futures and risk parity strategies for decades. The entire PIMCO’s StocksPLUS suite – which traces its history back to 1986 – is built on these foundations. The core strategy combines an actively managed portfolio of fixed income with 100% notional exposure in S&P 500 futures to create a 2x levered 50/50 portfolio.
The concept traces its roots back to the earliest eras of modern financial theory. Finding the maximum Sharpe ratio portfolio and gearing it to the appropriate risk level has always been considered to be the theoretically optimal solution for investors.
Nevertheless, after 2008, the words “leverage” and “derivatives” have largely been terms non gratisin the realm of investment products. But that may be to the detriment of investors.
90/60 Through the Decades
While we are proponents of the foundational concepts of the 90/60 portfolio, frequent readers of our commentary will not be surprised to learn that we believe there may be opportunities to enhance the idea through tactical asset allocation. After all, while a 90/60 may have out-performed over the long run, the short-run opportunities available to investors can deviate significantly. The prudent allocation at the top of the dot-com bubble may have looked quite different than that at the bottom of the 2008 crisis.
To broadly demonstrate this idea, we can examine the how the realized efficient frontier of stock/bond mixes has changed shape over time. In the table below, we calculate the Sharpe ratio for different stock/bond mixes realized in each decade from the 1920s through present.
Source: Global Financial Data. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. Bonds are the GFD Indices USA 10-Year Government Bond Total Return Index and Stocks are the S&P 500 Total Return Index (with GFD Extension). Sharpe ratios are calculated with returns excess of the GFD Indices USA Total Return T-Bill Index. You cannot invest in an index. 2010s reflect a partial decade through 4/2019.
We should note here that the original research proposed by Asness (1996) assumed a bond allocation to an Ibbotson corporate bond series while we employ a constant maturity 10-year U.S. Treasury index. While this leads to lower total returns in our bond series, we do not believe it meaningfully changes the conclusions of our analysis.
We can see that while the 60/40 portfolio has a higher realized Sharpe ratio than the 100% equity portfolio in eight of ten decades, it has a lower Sharpe ratio in two consecutive decades from 1950 – 1960. And the 1970s were not a ringing endorsement.
In theory, a higher Sharpe ratio for a 60/40 portfolio would imply that an appropriately levered version would lead to higher realized returns than equities at the same risk level. Knowing the appropriate leverage level, however, is non-trivial, requiring an estimate of equity volatility. Furthermore, leverage requires margin collateral and the application of borrowing rates, which can create a drag on returns.
Even if we conveniently ignore these points and assume a constant 90/60, we can still see that such an approach can go through lengthy periods of relative under-performance compared to buy-and-hold equity. Below we plot the annualized rolling 3-year returns of a 90/60 portfolio (assuming U.S. T-Bill rates for leverage costs) minus 100% equity returns. We can clearly see that the 1950s through the 1980s were largely a period where applying such an approach would have been frustrating.
Source: Global Financial Data. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Bonds are the GFD Indices USA 10-Year Government Bond Total Return Index and Stocks are the S&P 500 Total Return Index (with GFD Extension). The 90/60 portfolio invests 150% each month in the 60/40 portfolio and -50% in the GFD Indices USA Total Return T-Bill Index. You cannot invest in an index.
Poor performance of the 90/60 portfolio in this era is due to two effects.
First, 10-year U.S. Treasury rates rose from approximately 4% to north of 15%. While a constant maturity index would constantly roll into higher interest bonds, it would have to do so by selling old holdings at a loss. Constantly harvesting price losses created a headwind for the index.
This is compounded in the 90/60 by the fact that the yield curve over this period spent significant time in an inverted state, meaning that the cost of leverage exceeded the yield earned on 40% of the portfolio, leading to negative carry. This is illustrated in the chart below, with –T-Bills– realizing a higher total return over the period than –Bonds–.
Source: Global Financial Data. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. T-Bills are the GFD Indices USA Total Return T-Bill Index, Bonds are the GFD Indices USA 10-Year Government Bond Total Return Index, and Stocks are the S&P 500 Total Return Index (with GFD Extension). You cannot invest in an index.
This is all arguably further complicated by the fact that while a 1.5x levered 60/40 may closely approximate the risk level of a 100% equity portfolio over the long run, it may be a far cry from it over the short-run. This may be particularly true during periods where stocks and bonds exhibit positive realized correlations as they did during the 1960s through 1980s. This can occur when markets are more pre-occupied with inflation risk than economic risk. As inflationary fears abated and economic risk become the foremost concern in the 1990s, correlations between stocks and bonds flipped.
Thus, during the 1960s-1980s, a 90/60 portfolio exhibited realized volatility levels in excess of an all-equity portfolio, while in the 2000s it has been below.
This all invites the question: should our levered allocation necessarily be static?
Getting Tactical with a 90/60
We might consider two approaches to creating a tactical 90/60.
The first is to abandon the 90/60 model outright for a more theoretically sound approach. Specifically, we could attempt to estimate the maximum Sharpe ratio portfolio, and then apply the appropriate leverage such that we either hit a (1) constant target volatility or (2) the volatility of equities. This would require us to not only accurately estimate the expected excess returns of stocks and bonds, but also their volatilities and correlations. Furthermore, when the Sharpe optimal portfolio is highly conservative, notional exposure far exceeding 200% may be necessary to hit target volatility levels.
In the second approach, equity and bond exposure would each be adjusted tactically, without regard for the other exposure. While less theoretically sound, one might interpret this approach as saying, “we generally want exposure to the equity and bond risk premia over the long run, and we like the 60/40 framework, but there might be certain scenarios whereby we believe the expected return does not justify the risk.” The downside to this approach is that it may sacrifice potential diversification benefits between stocks and bonds.
Given the original concept of portable beta is to increase exposure to the risk premia we’re already exposed to, we prefer the second approach. We believe it more accurately reflects the notion of trying to provide long-term exposure to return-generating risk premia while trying to avoid the significant and prolonged drawdowns that can be realized with buy-and-hold approaches.
Equity Signals
To manage exposure to the equity risk premium, our preferred method is the application of trend following signals in an approach we call trend equity. We will approximate this class of strategies with our Newfound Research U.S. Trend Equity Index.
To determine whether our signals are able to achieve their goal of “protect and participate” with the underlying risk premia, we will plot their regime-conditional betas. To do this, we construct a simple linear model:
We define a bear regime as the worst 16% of monthly returns, a bull regime as the best 16% of monthly returns, and a normal regime as the remaining 68% of months. Note that the bottom and top 16thpercentiles are selected to reflect one standard deviation.
Below we plot the strategy conditional betas relative to U.S. equity
We can see that trend equity has a normal regime beta to U.S. equities of approximately 0.75 and a bear market beta of 0.5, in-line with expectations that such a strategy might capture 70-80% of the upside of U.S. equities in a bull market and 40-50% of the downside in a prolonged bear market. Trend equity beta of U.S. equities in a bull regime is close to the bear market beta, which is consistent with the idea that trend equity as a style has historically sacrificed the best returns to avoid the worst.
Bond Signals
To govern exposure to the bond risk premium, we prefer an approach based upon a combination of quantitative, factor-based signals. We’ve written about many of these signals over the last two years; specifically in Duration Timing with Style Premia(June 2017), Timing Bonds with Value, Momentum, and Carry(January 2018), and A Carry-Trend-Hedge Approach to Duration Timing(October 2018). In these three articles we explore various mixes of value, momentum, carry, flight-to-safety, and bond risk premium measures as potential signals for timing duration exposure.
We will not belabor this commentary unnecessarily by repeating past research. Suffice it to say that we believe there is sufficient evidence that value (deviation in real yield), momentum (prior returns), and carry (term spread) can be utilized as effective timing signals and in this commentary are used to construct bond indices where allocations are varied between 0-100%. Curious readers can pursue further details of how we construct these signals in the commentaries above.
As before, we can determine conditional regime betas for strategies based upon our signals.
We can see that our value, momentum, and carry signals all exhibit an asymmetric beta profile with respect to 10-year U.S. Treasury returns. Carry and momentum exhibit an increase in bull market betas while value exhibits a decrease in bear market beta.
Combining Equity and Bond Signals into a Tactical 90/60
Given these signals, we will construct a tactical 90/60 portfolio as being comprised of 90% trend equity, 20% bond value, 20% bond momentum, and 20% bond carry. When notional exposure exceeds 100%, leverage cost is assumed to be U.S. T-Bills. Taken together, the portfolio has a large breadth of potential configurations, ranging from 100% T-Bills to a 1.5x levered 60/40 portfolio.
But what is the appropriate benchmark for such a model?
In the past, we have argued that the appropriate benchmark for trend equity is a 50% stock / 50% cash benchmark, as it not only reflects the strategic allocation to equities empirically seen in return decompositions, but it also allows both positive and negative trend calls to contribute to active returns.
Similarly, we would argue that the appropriate benchmark for our tactical 90/60 model is not a 90/60 itself – which reflects the upper limit of potential capital allocation – but rather a 45% stock / 30% bond / 25% cash mix. Though, for good measure we might also consider a bit of hand-waving and just use a 60/40 as a generic benchmark as well.
Below we plot the annualized returns versus maximum drawdown for different passive and active portfolio combinations from 1974 to present (reflecting the full period of time when strategy data is available for all tactical signals). We can see that not only does the tactical 90/60 model (with both trend equity and tactical bonds) offer a return in line with U.S. equities over the period, it does so with significantly less drawdown (approximately half). Furthermore, the tactical 90/60 exceeded trend equity and 60/40 annualized returns by 102 and 161 basis points respectively.
These improvements to the return and risk were achieved with the same amount of capital commitment as in the other allocations. That’s the beauty of portable beta.
Source: Federal Reserve of St. Louis, Kenneth French Data Library, and Newfound Research. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. You cannot invest in an index.
Of course, full-period metrics can deceive what an investor’s experience may actually be like. Below we plot rolling 3-year annualized returns of U.S. equities, the 60/40 mix, trend equity, and the tactical 90/60.
Source: Federal Reserve of St. Louis, Kenneth French Data Library, and Newfound Research. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. You cannot invest in an index.
The tactical 90/60 model out-performed a 60/40 in 68% of rolling 3-year periods and the trend equity model in 71% of rolling 3-year periods. The tactical 90/60, however, only out-performs U.S. equities in 35% of rolling 3-year periods, with the vast majority of relative out-performance emerging during significant equity drawdown periods.
For investors already allocated to trend equity strategies, portable beta – or portable tactical beta – may represent an alternative source of potential return enhancement. Rather than seeking opportunities for alpha, portable beta allows for an overlay of more traditional risk premia, which may be more reliable from an empirical and academic standpoint.
The potential for increased returns is illustrated below in the rolling 3-year annualized return difference between the tactical 90/60 model and the Newfound U.S. Trend Equity Index.
Source: Federal Reserve of St. Louis, Kenneth French Data Library, and Newfound Research. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. You cannot invest in an index.
From Theory to Implementation
In practice, it may be easier to acquire leverage through the use of futures contracts. For example, applying portable bond beta on-top of an existing trend equity strategy may be achieved through the use of 10-year U.S. Treasury futures.
Below we plot the growth of $1 in the Newfound U.S. Trend Equity Index and a tactical 90/60 model implemented with Treasury futures. Annualized return increases from 7.7% to 8.9% and annualized volatility declines from 9.7% to 8.5%. Finally, maximum drawdown decreases from 18.1% to 14.3%.
We believe the increased return reflects the potential return enhancement benefits from introducing further exposure to traditional risk premia, while the reduction in risk reflects the benefit achieved through greater portfolio diversification.
Source: Quandl and Newfound Research. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. You cannot invest in an index.
It should be noted, however, that a levered constant maturity 10-year U.S. Treasury index and 10-year U.S. Treasury futures are not the same. The futures contracts are specified such that eligible securities for delivery include Treasury notes with a remaining term to maturity of between 6.5 and 10 years. This means that the investor short the futures contract has the option of which Treasury note to deliver across a wide spectrum of securities with potentially varying characteristics.
In theory, this investor will always choose to deliver the bond that is cheapest. Thus, Treasury futures prices will reflect price changes of this so-calledcheapest-to-deliver bond, which often does not reflect an actual on-the-run 10-year Treasury note.
Treasury futures therefore utilize a “conversion factor” invoicing system referenced to the 6% futures contract standard. Pricing also reflects a basis adjustment that reflects the coupon income a cash bond holder would receive minus financing costs (i.e. the cost of carry) as well as the value of optionality provided to the futures seller.
Below we plot monthly returns of 10-year U.S. Treasury futures versus the excess returns of a constant maturity 10-year U.S. Treasury index. We can see that the futures had a beta of approximately 0.76 over the nearly 20-year period, which closely aligns with the conversion factor over the period.
Source: Quandl and the Federal Reserve of St. Louis. Calculations by Newfound Research.
Despite these differences, futures can represent a highly liquid and cost-effective means of implementing a portable beta strategy. It should be further noted that having a lower “beta” over the last two decades has not necessarily implied a lower return as the basis adjustment can have a considerable impact. We demonstrate this in the graph below by plotting the returns of continuously-rolled 10-year U.S. Treasury futures (rolled on open interest) and the excess return of a constant maturity 10-year U.S. Treasury index.
Source: Quandl and Newfound Research. Calculations by Newfound Research. Returns are hypothetical and backtested. Returns are gross of all fees, transaction costs, and taxes. Returns assume the reinvestment of all distributions. You cannot invest in an index.
Conclusion
In a low return environment, portable beta may be a necessary tool for investors to generate the returns they need to hit their financial goals and reduce their risk of failing slow.
Historically, a 90/60 portfolio has outperformed equities with a similar level of risk. However, the short-term dynamics between stocks and bonds can make the volatility of a 90/60 portfolio significantly higher than a simple buy-and-hold equity portfolio. Rising interest rates and inverted yield curves can further confound the potential benefits versus an all-equity portfolio.
Since constant leverage is not a guarantee and we do not know how the future will play out, moving beyond standard portable beta implementations to tactical solutions may augment the potential for risk management and lead to a smoother ride over the short-term.
Getting over the fear of using leverage and derivatives may be an uphill battle for investors, but when used appropriately, these tools can make portfolios work harder. Risks that are known and compensated with premiums can be prudent to take for those willing to venture out and bear them.
If you are interested in learning how Newfound applies the concepts of tactical portable beta to its mandates, please reach out (info@thinknewfound.com).
We typically discuss trend following in the context of risk management for investors looking to diversify their diversifiers.
While we believe that trend following is most appropriate for investors concerned about sequence risk, levered trend following may have use for investors pursuing growth.
In a simple back-test, a naïve levered trend following considerably increases annualized returns and reduces negative skew and kurtosis (“fat tails”).
The introduced leverage, however, significantly increases annualized volatility, meaning that the strategy still exhibits significant and large drawdown profiles.
Nevertheless, trend following may be a way to allow for the incorporation of leverage with reduced risk of permanent portfolio impairment that would otherwise occur from large drawdowns.
In an industry obsessed with alpha, our view here at Newfound has long been to take a risk-first approach to investing. In light of this, when we discuss trend following techniques, it is often with an eye towards explicitly managing drawdowns. Our aim is to help investors diversify their diversifiers and better manage the potentially devastation that sequence risk can wreak upon their portfolios.
Thus, we often discuss the application of trend following for soon-to-be and recent retirees who are in peak sequence risk years.
Empirical evidence suggests that trend following can be a highly effective means of limiting exposure to significant and prolonged drawdowns.
Trend following is complementary to other diversifiers like fixed income, which can theoretically increase the Sharpe ratio of the diversification bucket as a whole.
Instead of acting as a static hedge, the dynamic approach of trend following can also help investors take advantage of market tailwinds. This may be particularly important if real interest rates remain low.
The potential tax inefficiency of trend following is significantly lower when the alternative risk management technique is fixed income.
Despite our focus on using trend following to manage sequence risk, we often receive questions from investors still within their accumulation phase asking whether trend following can be appropriate for them as well. Most frequently, the question is, “If trend following can manage downside risk, can I use a levered approach to trend following in hopes of boosting returns?”
This commentary explores that idea, specifically in the context of available levered ETFs.
Does Naïve Levered Trend Following Work?
In an effort to avoid overfitting our results to any one particular model or parameterization of trend following, we have constructed our signals employing a model-of-models approach [1] Specifically, we use four different definitions of trend for a given N-period lookback:
Price-Minus-Moving-Average: When price is above its N-period simple moving average, invest.Otherwise, divest.
EWMA Cross-Over: When the (N/4)-length exponentially-weighted moving average is above the (N/2)-length exponentially-weighted moving average, invest.Otherwise, divest.
EWMA Slope: When the (N/2)-length exponentially-weighted moving average is positively sloped, invest. Otherwise, divest.
Percentile Channel: When price crossed above the trailing 75thpercentile over the prior N-periods, invest. Stay invested until it crosses below its trailing 25thpercentile over the prior N-periods. Stay divested until it crosses back above the 75th
For each of these four models, we also run a number of parameterizations covering 6-to-18-month lookbacks. In grand total, there are 4 models with 5 parameterizations each, giving us 30 variations of trend signals.
Using these signals, we construct three models. In the first model, we simply invest in U.S. equities in proportion to the number of signals that are positive. For example, if 75% of the trend following signals are positive, the portfolio is 75% invested in U.S. equities and 25% in the risk-free asset.
For our leveraged model, we simply multiply the percentage of signals by 2x and invest that proportion of our portfolio in U.S. equities and the remainder in the risk-free asset. In those cases where the amount invested in U.S. equities exceeds 100% of the portfolio, we assume a negative allocation to the risk-free asset (e.g. if we invest 150% of our assets in U.S. equities, we assume a -50% allocation to the risk-free asset).
With the benefit of hindsight, we should not be surprised at the results. If we know that trend following is effective at limiting severe and prolonged drawdowns (the kryptonite to levered investors), then it should come as no surprise that a levered trend following strategy does quite well.
It is well worth pointing out, however, that a highly levered strategy can be quickly wiped out by a sudden and immediate drawdown that trend following is unable to sidestep. Assuming a 2x levered position, our portfolio would be quickly wiped out by a sharp 50% correction. While such an event did not happen during the 1900s for U.S. equities, that does not mean it cannot happen in the future. Caveat emptor.
Logarithmically-plotted equity curves can be deceiving, so it is important that we also compare the annual return characteristics.
Source: Kenneth French Data Library. Calculations by Newfound Research. Returns are gross of all fees, including transaction fees, taxes, and any management fees. Returns assume the reinvestment of all distributions. Past performance is not a guarantee of future results.
While we can see that a simple trend following approach effectively “clips” the tails of the underlying distribution – giving up both the best and the worst annual returns – the levered strategy still has significant mass in both directions. Evaluating the first several moments of the distributions, however, we see that both simple and levered trend following significantly reduce the skew and kurtosis of the return distribution.
Mean
Standard Deviation
Skew
Kurtosis
U.S. Equities
9.4%
19%
-1.01
1.36
Trend Following
9.5%
13%
0.09
-0.92
Levered Trend Following
14.4%
26%
0.11
-0.78
Nevertheless, the standard deviation of the levered trend following strategy exceeds even that of the underlying asset, a potential indication that expectations for the approach may be less about, “Can I avoid large drawdowns?” and more about, “Can I use leverage for growth and still avoid catastrophe?” We can see this by plotting the joint annual log-return distributions.
We can see that for U.S. equity returns between 0% and -20%, the Levered Trend Following strategy can exhibit returns between -20% and -40%. About 11% of the observations fall into this category, making it an occurrence that a levered trend follower should expect to experience multiple times in their investment lifecycle. We can even see one year where U.S. equities are slightly positive and the levered model exhibits a near -30% return. It is in the most extreme U.S. equity years – those exceeding -20% – that the trend following aspect appears to come into play.
We must also ask the question, “can this idea survive associated fees?” If investors are looking to apply this approach using levered ETFs, they must consider the expense ratios of the ETFs themselves, transaction costs, and bid/ask spreads. Here we will use the ProShares Ultra S&P 500 ETF (“SSO”) as a data proxy. The expense ratio is 0.90% and the average bid/ask spread is 0.03%. Since transactions costs vary, we will assume an added annual 0.20% fee for asset-based pricing.
In comparison, for the naïve model, we will use the SPDR S&P 500 ETF (“SPY”) as the data proxy and assume an expense ratio of 0.09% and an average bid/ask spread 0.004%. Since most platforms have a vanilla S&P 500 ETF on their no-transaction fee list, we will not add any explicit transaction costs.
We plot the strategy equity curves below net of these assumed fees.
The annualized return for the Levered Trend Following strategy declines from 15.9% to 14.5%, while the unlevered version only falls from 10.1% to 10.0%. While the overall return of the levered version declines by 140 basis points per year, it still far exceeds the total return performance of the unlevered version.
Conclusion
Based upon this initial analysis, it would appear that a simple, levered trend following approach may be worth further consideration for investors in the accumulation phase of their investment lifecycle.
Do-it-yourself investors may have no problem implementing this idea on their own using levered ETFs, but other investors may prefer a simple, packaged approach. Unfortunately, as far as we are aware, no such packaged product exists in the marketplace today.
However, one workaround may be to utilize levered ETFs to “make room” for an unlevered trend following strategy. For example, if a growth-oriented investor currently holdings an 80/20 stock/bond mix and wanted to introduce a 20% allocation to trend following, they could re-orient their portfolio to be 60% stocks, 10% 2x levered stocks, 10% 2x levered bonds, and 20% trend following. This would have the effect of being an 80/20 stock/bond portfolio with 20% leverage applied to introduce the trend following strategy. While there are the nuances of daily reset to consider in the levered ETF solutions, this approach may allow for the modest introduction of levered trend following into the portfolio.
It is worth noting that while we employed up to 2x leverage in this commentary, there is no reason investors could not apply a lower amount, either by mixing levered and unlevered ETFs, or by using a solution like the new Portfolio+ line-up from Direxion, which applies 1.25x leverage to underlying indices.
As we like to say here at Newfound, “risk cannot be destroyed, only transformed.” While this commentary explored levered trend following in comparison to unlevered exposure, a more apt comparison might simply be to levered market exposure. We suspect that the trend following overlay creates the same transformation: a reduction of the best and worst years at the cost of whipsaw. However, the introduction of leverage further heightens the risk of sudden and immediate drawdowns: the exact loss profile trend following is ill-suited to avoid.
[1] Nothing in this commentary reflects an actual investment strategy or model managed by Newfound and any investment strategies or investment approaches reflected herein are constructed solely for purposes of analyzing and evaluating the topics herein.
This blog post is available as a PDF download here.
Summary
We believe that capital efficiency should remain a paramount objective for investors.
The prudent use of leverage can help investors employ more risk efficient portfolios without necessarily sacrificing potential returns.
Many investors, however, do not have access to leverage (be it via borrowing or derivatives). They may, however, have access to leverage via Levered ETFs.
Levered ETFs are often dismissed as trading vehicles, not suited for buy-and-hold investors due to the so-called “volatility drag.” We show that the volatility drag is a component of all compounding returns, whether they are levered or not.
We explore the impact that the reset period can have on Levered ETFs and demonstrate how these ETFs may be used in the context of a portfolio to introduce diversifying, alternative exposures.
Early last month, we published a piece titled Portable Beta: Making the Most of the Returns You’re Already Getting, in which we outlined an argument whereby investors should focus on capital efficiency. We laid out four ways in which we believe that investors can achieve greater efficiency:
Reduce fees to take home more of what you earn.
Express active views more purely so that we are not caught paying active management prices for closet beta.
Focus on risk management by “diversifying your diversifiers” with strategies like trend following that can help increase exposure to higher return asset classes without necessarily increasing the overall portfolio risk profile.
Utilize modest leverage so that investors can create more risk-efficient portfolios without necessarily sacrificing potential return.
Unfortunately, for many investors, access to true leverage – either through borrowing or the use of derivatives – may be beyond their means. Fortunately, there are a number of ETFs available today that allow investors to access leverage in a packaged manner.
Wait, Aren’t Levered ETFs Dangerous?
Levered ETFs have quite a reputation, and not a good one at that. A quick search will result in numerous articles that tell you why they are a dangerous, bad idea. They are pejoratively dismissed as “trading vehicles,” unsuitable for “buy and hold.”
Most often, the negative publicity hinges on the concept of volatility decay (or, sometimes “volatility drag”). To illuminate this concept, let’s assume there is a stock that can only go up either +X% or down –X%. Thus, in any two-day period, we have the following growth in our wealth:
Up
Down
Up
(1 + X%)(1 + X%)
(1 – X%)(1 + X%)
Down
(1 + X%)(1 – X%)
(1 – X%)(1 – X%)
If we expand out the returns, we are left with:
Up
Down
Up
1 + 2X% + X%2
1 – X%2
Down
1 – X%2
1 – 2X% + X%2
Note that in the case where the stock went up +X% and then down -X% (or down –X% and then up +X%), we did not end up back at our starting wealth. Rather, we ended up with a loss of -X%2.
On the other hand, we can see that when the stock goes the same direction, we actually outperform twice the daily return by +X%2.
What’s going on here?
It is nothing more than the math of compound returns. The returns of the second day compound the returns of the first.
The effect earns the moniker volatility decay because in return environments that are mean-reversionary (e.g. positive returns follow negative returns, and vice versa), our capital decays due to the -X%2 term.
Note, however, that we haven’t even introduced leverage into the scenario yet. This drag is not unique to levered ETFs: it is just the math of compounding returns. Why it gets brought up so frequently with respect to levered ETFs is because the leverage can accentuate it. Consider what happens if we introduce a daily leverage factor of L:
Up
Down
Up
1 + 2LX% + L2X%2
1 – L2X%2
Down
1 – L2X%2
1 – 2LX% + L2X%2
When L=1, we have a standard long-only investment. When L=2, we have our 2X daily levered ETFs. What we see is that when L=1, our drag is simply –X%2. When L=2, however, our drag is 4X%2. When L=3, the drag skyrockets to 9X%2. Of course, the so-called drag turns into a benefit in trending markets (whether positive or negative).
So why do we not see this same effect when we use traditional leverage? After all, are these ETFs not using leverage under the hood to achieve their returns?
The answer lies in the daily reset. Note that these ETFs aim to give you a multiple of returns every day. The same is not true if we simply lever our notional exposure and never reset it. By “reset,” we mean pay back what we owe and re-borrow capital in order to maintain our leverage ratio.
To achieve 2X daily returns, the levered ETFs basically borrow their NAV, invest in the asset class, and then pay back what they borrowed. Hence, every day they reset how much they borrow.
If we never reset, however, the proportion of our capital that is levered varies over time. Consider, for example, investing $10,000 of our own capital in the SPDR S&P 500 ETF and borrowing another $10,000 to invest alongside (for convenience, we’re going to assume zero borrowing cost). As the market has gone up over time, the initial $10,000 borrowed becomes a smaller and smaller proportion of our capital.
Source: CSI. Calculations by Newfound Research. Assumes portfolio applies 100% notional leverage applied to SPDR S&P 500 ETF (“SPY”) at inception of ETF. Assumes zero cost of leverage.
This happens because while we owe the initial $10,000 back, the returns made on that $10,000 are ours to keep. In the beginning, our portfolio will behave very much like a 2X daily levered ETF. As the market trends upward over time, however, we not only compound our own capital, but compound our gains on the levered capital. This causes our actual leverage to decline over time. As a result, our daily returns will gradually converge towards that of the market.
In practice, of course, there would be a cost associated with borrowing the $10,000. However, the same fact pattern applies so long as the growth of the portfolio exceeds the cost of leverage.
Resetting, therefore, is a necessary component of maintaining leverage. On the one hand, we have daily resets, which keeps our leverage proportion constant. On the other hand, we have “never reset,” which will decay the leverage proportion over time (assuming the portfolio grows faster than the cost of leverage). There are, of course, shades of gray as well. Consider a 1-year reset:
Source: CSI. Calculations by Newfound Research. Assumes portfolio applies 100% notional leverage applied to SPDR S&P 500 ETF (“SPY”) at inception of ETF and reset every 252-days thereafter. Assumes zero cost of leverage.
Note that in 2008, the debt proportion of our balance sheet spiked up to nearly 90% of our capital. What happened? This is reset timing risk. On 4/2008, the portfolio reset, borrowing $92,574 against our equity of $92,574. Over the next year, the market fell approximately 39%. Our total assets tumbled from $185,148 to $114,753 and we still owed the initial $92,574 we borrowed. Thus, our actual equity over this period fell an astounding -76.7%.
(It is worth pointing out that if we had considered a “never reset” portfolio that started on 4/2008, we’d have the same result.)
Frequent readers of our commentary may be wondering, “can this reset timing risk be controlled with overlapping portfolios just like other timing risks?” Yes … ish. On the one hand, there is not a whole lot we can do about the drawdown itself: 100% notional leverage plus a 37% drawdown means you’re going to have a bad time. Where overlapping portfolios can help is in ensuring that resets do not necessarily occur at the worst possible point (e.g. the bottom of the drawdown) and lock in losses.
As a general rule, we probably don’t want to apply N-times exposure over a time frame an asset class can experience a return of -1/N%. For example, if we want 2x equity exposure, we want to make sure we reset our leverage exposure well before equities have a chance to lose 50% (1/2). Similarly, if we want 3x exposure, we need to reset well before we can lose 33.3% (1/3).
So, Are They Evil or What?
We would argue that volatility decay takes the blame when it is not actually the culprit. Volatility decay is nothing more than the math of compounding returns: it happens whether you are levered or not.
The danger of most levered ETFs is more easily explained. If I told you I was going to take your investment, use it as collateral to gain 100% notional exposure to equities, and then invest that collateral in equities as well – an asset class than can easily lose 50% –what would you say? When put that way, it sounds a little nuts. It really isn’t much more complicated than that.
The reset effect really just introduces a few more nuanced wrinkles. The more frequently we reset, the less risk we run of going bust, as we take risk off the table as our debt-to-equity ratio climbs. That’s how we can avoid complete ruin with 100% leverage in an asset class that falls more than 50%.
On the other hand, the more frequently we reset, the closer we keep the portfolio to the target volatility level, increasing the drag from short-term mean reversion.
We’ve said it before and we’ll say it again: risk cannot be destroyed, only transformed.
But, these things might have their use yet…
Levered ETFs in a Portfolio
Held as 100% of our wealth, a 2X daily reset equity ETF may not be too prudent. In the context of a portfolio, however, things change.
Consider, for example, using 50% of our capital to invest in a 2x equity exposure and the remaining 50% to invest in bonds. In effect, we have created 150% exposure to a 67/33 stock/bond mixture. For example, we could hold 50% of our capital in the ProShares Ultra S&P 500 ETF (“SSO”) and 50% in the iShares Core U.S. Bond ETF (“AGG”).
To understand the portfolio exposure, we have to look under the hood. What we really have, in aggregate, is: 100% equity exposure and 50% bond exposure. To get to 150% total notional exposure, we have to borrow an amount equal to 50% of our starting capital. Indeed, at the portfolio level, we cannot differentiate whether we are using that 50% borrowing to lever up stocks, bonds, or the entire mixture!
In this context, levered ETFs become a lot more interesting.
The risk, of course, is in the resets. To really do this, we’d have to rebalance our portfolio back to a 50/50 mix of the 2x levered equity exposure and bonds on a daily basis. If we could achieve that, we’d have built a daily reset 1.5x 66/33 portfolio.
More realistically, investors may be able to rebalance their portfolio quarterly. How far does that deviate from the daily rebalance? We plot the two below.
Source: CSI. Calculations by Newfound Research. Returns for the Daily Rebalance and Quarterly Rebalance portfolios are backtested and hypothetical. Returns are gross of all fees except underlying ETF expense ratios. Returns assume the reinvestment of all distributions. Cost of leverage is assumed to be equal to the return of a 1-3 Year U.S. Treasury ETF (“SHY”). Past performance is not indicative of future results. The Daily Rebalance portfolio assumes 50% exposure to a hypothetical index providing 2x daily exposure of the SPDR S&P 500 ETF (“SPY”) and 50% exposure to the iShares US Core Bond ETF (“AGG”) and is rebalanced daily. The Quarterly Rebalance portfolio assumes the same exposure, but rebalances quarterly.
Indeed, for aggressive investors, a levered equity ETF mixed with bond exposure may not be such a bad idea after all. However – and to steal a line from our friends at Toroso Asset Management – levered ETFs are likely “buy-and-adjust” vehicles, not buy-and-hold. The frequency of adjusting, and the cost of doing so, will play an important role in results.
A Particular Application with Alternatives
Where levered ETFs may be particularly interesting is in the context of liquid alternatives.
In the past, we have said that many liquid alternatives, especially those offered as ETFs, have a volatility problem. Namely, they just don’t have enough volatility to be interesting.
Traditionally, allocating to a liquid alternative requires us removing capital from one investment to “make room” in our portfolio, which creates an implicit hurdle rate. If, for example, we sell a 5% allocation of our equity portfolio to make room for a merger arbitrage strategy, not only do we have to expect that the strategy can create alpha beyond its fees, but it also has to be able to deliver a long-term return that is at least in the same neighborhood of the equity risk premium. Otherwise, we should be prepared to sacrifice return for the benefit of diversification.
One solution to this problem with lower volatility alternatives is to fund their allocation by selling bonds instead of stocks. Bonds, however, are often our stable ballast in the portfolio. Regardless of how poorly we expect core fixed income to perform over the next decade, we have a high degree of certainty in their return. Asking us to sell bonds to buy alternatives is often asking us to throw certainty out the window.
By way of example, consider the Reality Shares DIVS ETF (“DIVY”). We wrote about this ETF back in August 2016 and think it is a particularly compelling story. The ETF buys the floating leg of dividend swaps, which in theory captures a premium from investors who want to insure their dividend growth exposure in the S&P 500.
For example, if the swap is priced such that the expected growth rate of S&P 500 dividends is 5% over the next year, but the realized growth is 6%, then the floating leg keeps the extra 1%. The “insurance” aspect comes in during years where realized growth is below the expected rate, and the floating leg has to cover the difference. To provide this insurance, the floating leg demands a premium.
A dividend swap of infinite length should, in theory, converge to the equity risk premium. Short-term dividend swaps (e.g. 1-year), however, seem to exhibit a potentially unique risk premium, making them an interesting diversifier within a portfolio.
While DIVY has performed well since inception, finding a place for it in a portfolio can be difficult. With low volatility, we have two problems. First, for the fund to make a meaningful difference, we need to make sure that our allocation is large enough. Second, we likely have to slot DIVY in for a low volatility asset – like core fixed income – so that we make sure that we are not creating an unreasonable hurdle rate for the fund.
Levered ETFs may allow us to have our cake and eat it too.
For example, ProShares offers an Ultra 7-10 Year Treasury ETF (“UST”), which provides investors with 2x daily return exposure to a 7-10 year U.S. Treasury portfolio. For investors who hold a large portfolio of intermediate-term U.S. Treasuries, they could potentially sell some exposure and replace it with 50% UST and 50% DIVY.
As before, the question of “when to reset” arises: but even with a quarterly [rebalance, we think it is a compelling concept.
Source: CSI. Calculations by Newfound Research. Returns for the S&P 500 Dividend Swaps Index and 50% 2x Daily 7-10 Year US Treasuries / 50% Dividend Swap Index portfolios are hypothetical and backtested. Returns are gross of all fees except underlying ETF expense ratios. Returns assume the reinvestment of all distributions. Cost of leverage is assumed to be equal to the return of a 1-3 Year U.S. Treasury ETF (“SHY”). Past performance is not indicative of future results. The 50% 2x Daily 7-10 Year US Treasuries / 50% Dividend Swap Index assumes a quarterly rebalance.
Conclusion
Leverage is a tool. When used prudently, it can help investors potentially achieve much more risk-efficient returns. When used without care, it can lead to complete ruin.
For many investors who do not have access to traditional means of leverage, levered ETFs represent one potential opportunity. While branded as a “trading vehicle” instead of a buy-and-hold exposure, we believe that if prudently monitored, levered ETFs can be used to help free up capital within a portfolio to introduce diversifying exposures.
Beyond the leverage itself, the daily reset process can introduce risk. While it helps maintain the leverage ratio – reducing risk after losses – it also re-ups our risk after gains and generally will increase long-term volatility drag from mean reversion.
This daily reset means that when used in a portfolio context, we should, ideally, be resetting our entire portfolio daily. In practice, this is impossible (and likely imprudent, once costs are introduced) for many investors. Thus, we introduce some tracking error within the portfolio.
We should note that there are monthly-reset leverage products that may partially alleviate this problem. For example, PowerShares and ETRACS offer monthly reset products and iPath offers “no reset” leverage ETNs that simply apply a leverage level at inception and never reset until the ETN matures.
Perhaps the most glaring absence in this commentary has been a discussion of fees. Levered ETP fees vary wildly, ranging from as low as 0.35% to as high as 0.95%. When considering using a levered ETP in a portfolio context, this fee must be added to our hurdle rate. For example, if our choice is between just holding the iShares 7-10 Year U.S. Treasury ETF (“IEF”) at 0.15%, or 50% in the ProShares Ultra 7-10 Year Treasury ETF (“UST”) and 50% in the Reality Shares DIVS ETF (“DIVY”) for a combined cost of 0.93%, the extra 0.78% fee needs to be added to our hurdle rate calculation.
Nevertheless, as fee compression marches on, we would expect fees in levered ETFs to come down over time as well, potentially making these products interesting for more than just expressing short-term trading views.
Source: Tiingo, Bloomberg, Barcharts. Calculations by Newfound Research. Past performance is backtested and hypothetical. Returns are gross of all fees, costs, and taxes except for underlying expense ratios. Returns assume the reinvestment of all distributions. Past performance is not indicative of future results. Starting date based upon the availability of pricing data.
Does it matter which we choose? Does an inverted yield curve make the first choice less attractive than the second?
Source: Bloomberg.
The expected return of a portfolio, then, can simply be thought of as the risk-free rate plus the blended return of risk premia. For example, the expected return of a 60/40 is:
Diversification with Portable Beta
By Nathan Faber
On February 18, 2020
In Craftsmanship, Portfolio Construction, Risk & Style Premia, Risk Management, Weekly Commentary
This post is available as a PDF download here.
Summary
Portable beta strategies seek to enhance returns by overlaying an existing portfolio strategy with complementary exposure to diversifying asset classes and strategies. In overlaying exposure on an existing portfolio strategy, portable beta strategies seek to make every invested dollar work harder. This idea can create “capital efficiency” for investors, freeing up dollars in an investor’s portfolio to invest in other asset classes or investment opportunities.
At Newfound, we focus on managing risk. Trend following – or absolute momentum – is a key approach we employ do this, especially in equities. Trend equity strategies are a class of strategies that aim to harvest the long-term benefits of the equity risk premium while managing downside risk through the application of trend following.
We wrote previously how a trend equity strategy can be decomposed into passive and active components in order to isolate different contributors to performance. There is more than one way to do this, but in the most symmetric formulation, a “long/flat” trend equity strategy (one that that either holds equities or cash; i.e. does not short equities) can be thought of as a 100% passive allocation to a 50/50 portfolio of stocks and cash plus a 50% overlay allocation to a long/short trend equity strategy that can move between fully short and fully long equities. This overlay component is portable beta.
We have also written previously about how a portable beta overlay of bonds can be beneficial to trend equity strategies – or even passive equity investments, for that matter. For example, 95% of a portfolio could be invested in a trend equity strategy, and the remaining 5% could be set aside as collateral to initiate a 60% overlay to 10-year U.S. Treasury futures. This approximates a 60/40 portfolio that is leveraged by 50%
Source: Newfound. Allocations are hypothetical and for illustrative purposes only.
Since this bond investment introduces interest rate risk, we have proposed ways to manage risk in this specific sleeve using factors such as value, carry, and momentum. By treating these factors as fully tactical long/short portfolios themselves, if we hold them in equal weight, we can also break down the tactical U.S. Treasury futures overlay into active and passive components, with a 30% passive position in U.S. Treasury futures and 10% in each of the factor-based strategies.
Source: Newfound. Allocations are hypothetical and for illustrative purposes only.
When each overlay is fully invested, the portfolio will hold 95% stocks, 5% cash, and 60% U.S. Treasury futures. When all the overlays are fully short, the strategy will be fully invested in cash with no bond overlay position.
While the strategy has not changed at all with this slicing and dicing, we now have a framework to explore the historical contributions of the active and passive components and the potential diversification benefits that they offer.
Diversification Among Components
For the passive portfolio 50/50 stock/cash, we will use a blend of the Vanguard Total U.S. stock market ETF (VTI) and the iShares Short-term Treasury Bond ETF (SHV) with Kenneth French data for market returns and the risk-free rate prior to ETF inception.
For the active L/S Trend Equity portfolio, we will use a long/short version of the Newfound U.S. Trend Equity Index.
The passive 10-year U.S. Treasury futures is the continuous futures contract with a proxy of the 10-year constant maturity Treasury index minus the cash index used before inception (January 2000). The active long/short bond factors can be found on the U.S. Treasuries section of our quantitative signals dashboard, which is updated frequently.
All data starts at the common inception point in May 1957.
As a technical side note, we must acknowledge that a constant maturity 10-year U.S. Treasury index minus a cash index will not precisely match the returns of 10-year U.S. Treasury futures. The specification of the futures contracts state that the seller of such a contract has the right to deliver any U.S. Treasury bond with maturity between 6.5 and 10 years. In other words, buyers of this contract are implicitly selling an option, knowing that the seller of the contract will likely choose the cheapest bond to deliver upon maturity (referred to as the “cheapest to deliver”). Based upon the specification and current interest rate levels, that current cheapest to deliver bond tends to have a maturity of 6.5 years.
This has a few implications. First, when you buy U.S. Treasury futures, you are selling optionality. Finance 101 will teach you that optionality has value, and therefore you would expect to earn some premium for selling it. Second, the duration profile between our proxy index and 10-year U.S. Treasury futures has meaningfully diverged in the recent decade. Finally, the roll yield harvested by the index and the futures will also diverge, which can have a non-trivial impact upon returns.
Nevertheless, we believe that for the purposes of this study, the proxy index is sufficient for broad, directional attribution and understanding.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
The 50/50 Stock/Cash portfolio is the only long-only holding. While the returns are lower for all the other strategies, we must keep in mind that they are all overlays that can add to the 50/50 portfolio rather than simply de-risk and cannibalize its return.
This is especially true since these overlay strategies have exhibited low correlation to the 50/50 portfolio.
The table below shows the full period correlation of monthly returns for all the portfolio components. The equity and bond sub-correlation matrices are outlined to highlight the internal diversification.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Not only do all of the overlays have low correlation to the 50/50 portfolio, but they generally exhibit low cross-correlations. Of the overlays, the L/S bond carry and L/S bond momentum strategies have the highest correlation (0.57), and the L/S bond carry and passive bond overlay have the next highest correlation (0.47).
The bond strategies have also exhibited low correlation to the equity strategies. This results in good performance, both absolute and risk-adjusted, relative to a benchmark 60/40 portfolio and a benchmark passive 90/60 portfolio.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Finding the Optimal Blend
Up to this point, we have only considered the fixed allocations to each of the active and passive strategies outlined at the beginning. But these may not be the optimal holdings.
Using a block-bootstrap method to simulate returns, we can utilize mean-variance optimization to determine the optimal portfolios for given volatility levels.1 This yields a resampled historical realized efficient frontier.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Plotting the benchmark 60/40, benchmark 90/60, and the tactical 90/60 on this efficient frontier, we see that the tactical 90/60 lies very close to the frontier at about 11.5% volatility. The allocations for the frontier are shown below.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
As expected, the lower volatility portfolios hold more cash and the high volatility portfolios hold more equity. For the 9% volatility level, these two allocations match, leading to the full allocation to a 50/50 stock/cash blend as in the tactical 90/60.
The passive allocation to the Treasury futures peaks at about 60%, while the L/S bond factor allocations are generally between 5% and 20% with more emphasis on Value and typically equal emphasis on Carry and Momentum.
The allocations in the point along the efficient frontier that matches the tactical 90/60 portfolio’s volatility are shown below.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
In this portfolio, we see a higher allocation to passive equities, a smaller position in the tactical equity L/S, and a larger position in passive Treasury futures. However, given the resampled nature of the process, these allocations are not wildly far away from the tactical 90/60.
The differences in the allocations are borne out in the Ulcer Index risk metric, which quantifies the severity and duration of drawdowns.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
The efficient frontier portfolio has a lower Ulcer Index than that of the tactical 90/60 even though their returns and volatility are similar. However, the Ulcer index of the tactical 90/60 is very close to that of the benchmark 60/40.
These differences are likely due to the larger allocation to the tactical equity long/short which can experience whipsaws (e.g. in October 1987), the lower allocation to passive U.S. equities, and the lower allocation to the Treasury overlay.
In an uncertain future, there can be significant risk in relying too much on the past, but having this framework can be useful for gaining a deeper understanding of which market environments benefit or hurt each component within the portfolio and how they diversify each other when held together.
Conclusion
In this research note, we explored diversification in a long/flat tactical equity strategy with a portable beta bond overlay. By decomposing the strategy into its passive holdings (50/50 stock/bond portfolio and U.S. Treasury futures) and active long/short overlays (trend equity, bond carry, bond momentum, and bond value), we found that each of the overlays has historically exhibited low correlation to the passive portfolios and low cross-correlations to each other. Combining all of these strategies using a tactical 90/60 portfolio has led to strong performance on both an absolute and risk-adjusted basis.
Using these strategy components, we constructed an efficient frontier of portfolios and also found that the “intuitive” tactical 90/60 portfolio that we have used in much of our portable beta research is close to the optimal portfolio for its volatility level. While this does not guarantee that this portfolio will be optimal over any given time period, it does provide evidence for the robustness of the multi-factor risk-managed approach.
Utilizing portable beta strategies can be an effective way for investors to pursue capital efficiency and maximize portfolio returns while simultaneously managing risk. While leverage can introduce risks of its own, relying on diversification and robust risk-management methods (e.g. trend following) can mitigate the risk of large losses.
The fear of using leverage and derivatives may be an uphill battle for investors, and there are a few operational burdens to overcome, but when used appropriately, these tools can make portfolios work harder and lead to more flexibility for allocating to additional opportunities.
If you are interested in learning how Newfound applies the concepts of tactical portable beta to its mandates, please reach out (info@thinknewfound.com).