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Thursday, November 30, 2017

Volatility and Leveraged instruments to Lazily beat the markets (Part 3)

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) since 2011.

In the second part of the series we looked at short volatility instruments, which unlike UPRO, tend to go up when the market is going sideways. Combinations of either XIV or ZIV with bonds easily beat the markets too, but it was a pretty volatile ride, especially for XIV, which I personally prefer to not be invested in.

Today, we are going to combine all three: Triple Leveraged S&Ps, Short Volatility and Bonds as the hedging component.
When we simultaneously invest in UPRO and ZIV, we are giving our capital enormous appreciation potential. However, if things go wrong and the market tanks, the suffering is multiplied. For this reason, I thought it would be worth it to explore the hedging potential of Triple Leveraged Bonds (TMF) and not just TLT, as its increased hedging capability against market falls may be necessary to compensate the bleeding of both UPRO and ZIV.
The portfolio is re-balanced each year to start off with the correct % allocations. i.e 25% UPRO, 25% ZIV and 50% TMF, etc.

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

We've got some very interesting numbers here.

A couple of observations:

- Every time you use Triple Leveraged Bonds (TMF) instead of TLT, the Average Annual Return increases in the long run.

- Every time you use Triple Leveraged Bonds, the volatility of the returns increases, becoming more disperse and unpredictable.

The most interesting allocations to me:
- 20 UPRO, 20 ZIV, 60 TLT  (18.94% annual return with a very small standard deviation)
- 25 UPRO, 25 ZIV, 50 TLT  (21.70% annual return and a decent 1.54 ratio of Returns to Standard Dev)
- 30 UPRO, 30 ZIV, 40 TMF (30.64% annual return)
- 33 UPRO, 33 ZIV, 33 TMF (31.45% annual return)

I added a final bonus combination (30 ZIV / 40 TLT / 30 Cash). Seemed funny to me that being invested at just 70% you almost match the average returns of the S&P500 with less pain.

Granted, this summary of yearly returns doesn't paint the whole picture. An important component is how those equity curves look on a daily basis. How cruel the draw-downs are during the worst times. How long they take. How deep they are. But at least we now have a general idea on the validity of these combinations. We have also been in a bull market and it is expected that any combination of UPRO and ZIV will inflate those returns easily.

In the next chapter we'll use simulated data for UPRO, ZIV and TMF that goes back to 2008 (before the inception of these instruments). That way, we'll have a more realistic idea about how all this will work (or not) during a serious systemic crisis. Stay tuned.

Thanks for reading,

Related Articles:
Volatility and Leveraged instruments to Lazily beat the markets (Part 1)
Volatility and Leveraged instruments to Lazily beat the markets (Part 2)

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