Why Bill Gross Is Wrong But Borrowing Is Right

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Includes: GLD, SPY, SSO, TLT, UBT, UGL
by: Hedgewise

Summary

With interest rates back near all-time lows, Bill Gross recently told Barron's that investors should consider borrowing to boost returns.

But the highly levered bets he recommends are poor choices for most investors.

Borrowing makes sense, but keep it simple with a diversified mix that has outperformed for decades.

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In a near-zero interest rate world, Bill Gross is spot on about the benefits of borrowing. There seems to be a general consensus that stock returns will be meager for some time, and 10-year bonds are yielding a paltry 1.7%. If you inject a bit of cheap leverage to the equation, though, you can quickly turn a measly return into a far more attractive one.

While this may be true in theory, it is a path rife with dangers. Heavily levered firms played a big role during the Great Recession of 2008. Even if you have access to cheap capital, you also need to find assets with extremely predictable, low-risk returns.

Unfortunately, the funds that Gross recommends to investors fail to meet these criteria. However, there is one leveraged bet that passes the "timeless and universal" test which has already been significantly outperforming in 2016. It isn't exposed to risk in a specific industry, and it is extremely resilient against stock crashes and rising interest rates. It's easy to construct and accessible to every investor.

If you lever this mix up by as little as 50%, you get a better return with less risk in nearly every decade that you can measure. Chances are that the next 10 years will be no different. We'll show you how to easily create this portfolio yourself, and prove to you why it is the rare case when leverage makes good sense.

The Gross Miscalculation: Trouble With Leverage

Because leverage amplifies both risk and returns, it must be used quite cautiously. In particular, you want to stay away from any concentrated, non-diversified sources of risk, such as a single company or even a single asset class.

For example, US Treasuries are considered one of the safest assets around. Despite this, levering up 5x into 20-year bonds is probably a very bad idea. If interest rates rose by even 1%, you'd go nearly bankrupt. When a single, relatively commonplace event can destroy your entire portfolio, it's probably time to reconsider.

This risk is further amplified as you decrease your level of diversification. A single corporate bond is far riskier than a balanced portfolio of many corporate bonds, just as a single stock is far riskier than a balanced portfolio of stocks. Yet Gross' top recommendation is to consider 'merger-arbitrage' plays like the current InBev (NYSE:BUD) bid for SABMiller (LON:SAB) -- perhaps the definition of a very specific, very isolated, highly volatile event.

His next category of leveraged bets are mortgage REITs like Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), which are levered 4-6x. After the real estate meltdown in 2008, it's pretty shocking that anyone would label these companies as either predictable or low risk. The minute we hit another recession and see any kind of price dip in housing, you'll want to be as far away from these firms as possible (Annaly was down over 40% from 2008 to 2009).

Finally, he recommends a few closed-end funds that build leverage into their strategy, such as the Nuveen Preferred Income fund (NYSE:JPC) and the Duff & Phelps Global Utility fund (NYSE:DPG). While these companies are theoretically closer to a good bet -- they only use 1.3-1.5x leverage, and the funds are relatively well-diversified -- they are still both very isolated in a single asset class. NPC only deals with preferred securities, which are highly sensitive to interest rate changes, while DPG invests only in utility stocks. Oh, and by the way, they are both rated two stars on Morningstar and have expense ratios around 1.5%. No thanks!

Is No Leverage The Answer?

You might already be thinking 'duh' - -I knew it was crazy the minute I saw the word 'leverage'. However, I've noticed a consistent theme in many of the comment boards lately that lots of bets seem crazy. With interest rates near zero, you'd be crazy to invest in long-term bonds. With stocks probably near the end of this bull market, you'd be crazy to buy equities. With oil moving up and down 20% every week, you'd be crazy to buy energy.

Against this wall of worry, there are only three realistic options for most long-term investors:

1) Move to cash and wait to invest until the next recession

2) Keep a broadly diversified portfolio, but brace for meager returns in the next 3-5 years

3) Add a small amount of leverage to the diversified portfolio to boost your outlook without adding dangerous, idiosyncratic risk

We'll show you why cash is almost certainly a bad move, and examine whether adding leverage makes sense and why.

The Timeless Magic Of Diversification

As we've discussed in-depth in many of our previous articles, diversification is one of the only guaranteed ways to boost your returns and decrease your risk. This effect is maximized when you have a portfolio of many uncorrelated assets balanced in the right proportion to one another.

While that may seem like a hard portfolio to construct, you can use history to identify the exact 'optimal mix' over any given time frame. If we limit this analysis to broad, US-only asset classes -- stocks, bonds, and commodities -- this optimal mix comes out to around 60% bonds (NYSEARCA:TLT) / 30% stocks (NYSEARCA:SPY) / 10% gold (NYSEARCA:GLD) since 1970.

S&P 500 vs. 60/30/10 Mix Total Return, January 1970 - Present

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Source: Yahoo Finance, WSJ, Hedgewise Analysis

Though the S&P has a higher total return, the 60/30/10 mix gets you a much better "risk-adjusted" return, which basically means you avoid the huge drawdowns along the way. Another way to see this is by examining the rolling 3-year returns of the two portfolios, which answers, "What is the worst I could have done over any 3-year period?"

3 Year Rolling Returns, S&P 500 vs. 60/30/10 Mix

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Source: Yahoo Finance, WSJ, Hedgewise Analysis

While the S&P 500 has had multiple 3-year periods where you lose nearly half your money, the 60/30/10 mix has had zero!

This means that you would have NEVER been better in cash over any 3-year period.

This also means that the 60/30/10 mix has been a very resilient bet across many vastly different kinds of investment environments, including high inflation, low inflation, high growth, and recessions. At worst, you get a total return of around 10%. However, if this is truly a low risk, predictable kind of investment, is it safe to add some leverage?

The Case For 50% Leverage

To test this, we added 50% leverage to this mix across the entire time frame, and assumed that the cost of that leverage was equivalent to the rate on 1-year treasury bills (which is quite accessible if you know how to generate leverage in the options or futures market).

S&P 500 vs. 60/30/10 Mix Plus 50% Leverage Total Return, January 1970 - Present

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By using a moderate amount of leverage (1.5x), and keeping to an extremely conservative mix of assets, we are able to significantly boost our overall return with significantly less risk than the S&P 500.

The conclusion is hard to deny: leverage makes sense in this kind of portfolio, and can be especially useful in environments that would otherwise yield low returns.

Caveats

Many of you may take issue with constructing this portfolio based on historical data. What if the next 30 years are nothing like the last 30? While the future will certainly be different, it is hard to imagine a scenario where diversification fails entirely. Perhaps the ideal portfolio will be a little heavier or a little lighter in some areas, but these concepts should still apply even if you are anywhere in the right ballpark.

That said, if you'd like to get closer to estimating the 'optimal mix' of the future, there are a number of techniques that may be helpful, such as the risk parity framework. We'll also be posting another article soon that estimates what this might look like for the next 10 years (be sure to "follow" us!).

It's also important to understand that the benefits of this framework play out over many years, not a few short months.

Finally, you need to be comfortable generating leverage in your own portfolio in order to apply these concepts. This can be done most efficiently by using either futures or options contracts directly, but you can also use leveraged ETFs such as the Ultra S&P 500 ETF (NYSEARCA:SSO), the Ultra 20+ Yr Treasury ETF (NYSEARCA:UBT), and the Ultra Gold ETF (NYSEARCA:UGL). Note that these types of funds must be managed very carefully due to the nature of daily rebalancing.

Takeaways

Investors are being forced to grapple with the prospect of muted returns for the foreseeable future. While leverage is a tempting way to get around this problem, it is a big mistake to use it recklessly. Unfortunately, Bill Gross has recommended a number of sectors that badly amplify the risks of borrowing, and could easily leave investors shirtless.

However, this doesn't mean leverage is a bad idea altogether. In fact, when applied to a highly diversified, conservative portfolio like the 60% bond / 30% stock / 10% gold mix, leverage has historically boosted your returns while remaining below the overall risk level of the S&P 500. In a world of few sure bets, we believe this mix is quite worthy of consideration.

Disclosure: I am/we are long SPY, GLD, TLT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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