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Tuesday, November 21, 2017

Volatility and Leveraged instruments to Lazily beat the markets (Part 2)

In the first part of this series we examined the viability of investing in triple leveraged SPX via UPRO. With the potential to triple the market's returns comes added risk (larger draw-downs) and hence the idea of using UPRO in only a portion of the account. A simple combination of one third of an account holding UPRO (basically attempting to match the markets returns on the whole) combined with another instrument with a historical upside bias such as Bonds (TLT) which, additionally offers hedging potential as it generally moves up in times of crises (UPRO going down) easily beat the market (18.17% annual return vs 13.37% SPY). It also did so while scoring a respectable 1.68 ratio of Average Annual Return to Standard Deviation of Returns (a simplified version of Sharpe).

We also learned that the real enemy of leveraged instruments is sideways price action, where they tend to under-perform their underlying non-leveraged index over time, even losing money while the underlying index stays neutral.

There is one type of instrument though, that generally moves up when the price of the market is sideways. Do you dare to guess?

- Yeah, that was a tough one. The answer is "short volatility instruments". Things such as XIV (short near-term volatility) or ZIV (short medium-term volatility) tend to go up in periods of low volatility. Usually, if the market (S&P500) stays sideways for an extended period of time volatility tends to decrease and this is reflected by up moves in both XIV and ZIV. In the same sideways action period, UPRO would be losing money due to the phenomenon explained in Part 1

The beauty of these instruments is that they will also go up when the market goes up, as an up-trending market typically brings a decreasing VIX. So, we have found our Holy Grail!

Well, not so fast. XIV and ZIV are extremely volatile instruments. When things go well, life is great, but as soon as the markets start to fall, they suffer like no other instrument. Take a look at a multi-year XIV chart and let the market Gods take your breath away. And those falls have been during one of the most bullish periods in history!

XIV in particular is much more volatile than ZIV. Both instruments benefit form the Contango that exists about 85% of the time in the VIX futures. ZIV is based on the Contango from the 4th to the 7th month out and these tend to trade in Backwardation much less often than the near term futures used by XIV. For this reason, the ride with ZIV is less volatile than if you were invested in XIV.

Just as we did with UPRO in part 1, we will hedge the draw-downs of ZIV and XIV using bonds, which will tend to go up when fear comes to the markets and ZIV and XIV fall. Also, at the beginning of each year, the capital in the portfolio is re-balanced to start off with the correct allocations, i.e 33% ZIV + 66% TLT, etc.

Without further ado:
*2017 numbers were as of November 10.

As you can see, all these combinations of either XIV or ZIV with Bonds beat the SPY in terms of Average Annual Return. I would not be able to mentally handle the volatility of XIV. It is just too wild for me, even when hedged with bonds (see the STD DEV column), but that's just a personal preference.

I particularly like the combination of 40% invested in ZIV and 60% in TLT as it gives a nice return with volatility under some control and it still shows a better ratio of Returns to Volatility than the SPY.

So, that's all for Part 2.

In the next chapter we will combine the best of both worlds by investing in UPRO, ZIV and TLT at the same time. UPRO to take advantage of those strong uptrends; ZIV to take advantage of both uptrends and sideways price action (naturally hedging UPRO's fall during market's sideways periods) and Bonds, to partially hedge the losses on both UPRO and ZIV during market falls.

I'll also explore the potential benefits of Triple Leveraged Bonds (TMF). If we are going to go crazy, let's do it really well.

The main question still remains though:  
How would all these triple leveraged and short-vol instruments fair during a true recession a la 2008?
That my friends, will be answered in Part 4.
Even though neither ZIV nor UPRO existed prior to the financial crisis, their data can be artificially simulated. Your pal LT is here to the rescue. We'll simulate all these allocations and analyze the results for 2007, 2008, 2009 and 2010. No more question marks. No more "what ifs". Stay tuned!

Thanks for reading,
LT

Related Articles:
Volatility and Leveraged instruments to Lazily beat the markets (Part 1)
Volatility and Leveraged instruments to Lazily beat the markets (Part 3)


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