By Roger Nusbaum, AdvisorShares ETF Strategist
A long-time reader sent a link to an article from Forbes titled Leverage Your Way To A Richer Retirement. The article considered research done by Jason Scott at Financial Engines which looked at completely revamping the 4% rule (the 4% rule pertains to the optimal withdrawal rate for a retiree take from their portfolio without exhausting their funds).
Scott's portfolio is called the floor leverage rule and the basic idea put forward is to put the vast majority of the portfolio into bonds or perhaps TIPS to guarantee some minimum level of income from the portfolio. The suggested allocation was 85%.
Scott views the fixed income allocation in an interesting way. Based on prevailing yields how much needs to be invested to generate $1000 in annual income. Per the numbers cited $25,000 would generate $1000 per year from TIPS and that $19,000 would buy $1000 of income from a zero coupon ladder. Obviously then, $1 million in the bond bucket would generate $40,000 from a TIPS portfolio (again, these are numbers cited in the Forbes article).
Scott then avers that the remaining 15% goes in to 3x levered ETFs tracking a broad equity index. As the market rises the idea would be to regularly and frequently rebalance excess from the equity portion into the fixed income to buy more zeros or TIPS, thus increasing the portfolio's income. If the market is headed lower then "you simply watch it go down and hope it recovers."
If the concept sounds vaguely familiar that's because you've probably read about something similar from Boston University professor Zvi Bodie and also from Nassim Taleb. The bigger idea from all three is that high risk is concentrated in a very small portion of the portfolio. They all have different ideas about how to take that risk.
To the Jason Scott portfolio, read the article to get a sense of the work involved in back testing the idea and also to get a handle on Scott's chops, having gotten a doctorate from Stanford.
While there will be very few who can out-debate Scott on putting 15% of their portfolio into a 3x levered index fund and then just gritting your teeth, but that does not necessarily mean Scott is right either.
The Forbes article offers some numbers about how the daily reset can work against the portfolio and also work for it but there is a crucial point of understanding with any levered funds which is not so much that the do or don't track their targeted index over time but that sometimes they do indeed track their index but only sometimes. There are other times when they do not and there is no way to know what they will do in the future; by definition.
Forbes gave the impression that Financial Engines might be working on a way to deliver the strategy in a product for its clients but that for now there was no such vehicle. Given the unpredictability of levered funds it might make more sense for anyone actually considering this to study whether long term index calls might make more sense.
Using call options would require less capital for the same equity exposure depending on the strike price chosen. In addition to index options, ETF options would be another possibility for executing the strategy. Options are more along the lines of what Taleb has talked about in this context.
In the real world it is very difficult to imagine too many people going down this road but there are learning points related to how much exposure to risk assets a client (or do-it-yourselfer) actually needs or can tolerate.
Far too many people have the wrong asset allocation for the totality of their situation and extreme concepts like the floor leverage rule provide an opportunity to revisit what is best for clients or yourself.
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