'Hell On Fire' - The 3x Leveraged Universal Investment Strategy (Part I)

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Includes: SPXL, SPY, TLT, TMF
by: Frank Grossmann

Summary

Aggressive leveraged version of our previously published Universal Investment Strategy.

Variable SPY-TLT allocations dynamically adapted to the market conditions.

45% annual return with a Sharpe Ratio of 1.3 during synthetic backtest since 2002.

We have received a lot of constructive feedback after our recent article introducing the "UIS Universal Investment Strategy". Many bloggers have contributed to validate and further improve the strategy with their own backtests, among them Ilya Kipnis from QuantStrat Trader, and Michael Kaplan from Systematic Investor. In its January 2015 meeting, Al Zmyslowski and the CI-MI group of the AAII Silicon Valley discussed the Strategy in detail. They were kind enough to post the videos (Part I, II and III).

Due to its simplicity and low correlation to the S&P 500, there is a continued interest in the UIS version that uses 3x leveraged ETFs: ETF SPXL (Direxion Daily S&P 500 Bull 3X Shares ETF) and TMF (Direxion Daily 30-Year Treasury Bull 3x Shares ETF). Following the suggested nomenclature by Al from AAII SV - and to honor their interest, we call this version "Hell on fire", which alludes to the high risk/return profile of the strategy. We will show ways to blend this strategy in a well-balanced and risk-optimized portfolio as to overcome the generally negative perception of private investors towards leveraged ETF.

The interested reader might ask, why a separate article for this? Why not simply use the signals of the non-leveraged strategy, but execute with the leveraged ETF? Or just use margin? We will come back to this question after introducing some methodology used in our extended backtest.

Construction of Synthetic time series for extending backtest

Due to the limited history of both SPXL and TMF we decided to extend the time series to include the 2008-2009 timeframe.

The approach we took was to determine a multiplication factor to the daily returns of SPY and TLT which would minimize the sum of squared differences of the leveraged and non-leveraged versions. Applying the resulting factor of 2.84 (3.04) visually confirms the good fit.

Back to the question of why not apply the UIS signals to trading 3x leveraged ETF? The answer lies in the effective leverage both ETFs offer versus the base version.

While SPXL with a factor of 2.84 falls short of the 3.0 leverage target, TMF delivers a 0.28 higher leverage, and with a factor of 3.04 more than delivers the targeted leverage. We show that using the synthetic 3x leveraged time series in the algorithm results in more exact and better performing trading signals.

For the backtest we employ the same maximum 'modified Sharpe Ratio' algorithm as introduced in the original UIS. Normally the Sharpe ratio is calculated by Sharpe = rd/sd with rd = mean daily return and sd = standard deviation of daily returns. We don't use the risk free rate, as we only use the Sharpe ratio for ranking purposes.

Our algorithm uses a modified Sharpe formula Sharpe = rd/(sd^f) with f=volatility factor. The f factor allows us to change the importance of volatility.

We analyze the performance of three different backtests and present the charts from our "QuantTrader" software:

1. Our formerly introduced 'plain' UIS for the time period of Jan 2002 - Mar 2015

2. The 3x times leveraged UIS employing SPXL and TMF since its inception in 2009 to Mar 2015

3. The 3x times leveraged UIS employing the synthetically extended SPXL and TMF from 2002 to Mar 2015

4. Same as 3), but using the same lookback period and f factor as in 2). This to confirm the parameter stability of our extended backtest, discussed later.

5. The underlying ETF SPY and TLT in their plain version, 3 times leveraged - synthetically extended to 2002.

The performance statistics of the backtests and their underlying ETF in comparison:

CAGR %

Volatility %

Sharpe

Max DrawDown %

1.

UIS SPY/TLT 2002 - 2015

13.57

10.10

1.34

-17.13

2.

UIS SPXL/TMF 2009 - 2015

53.27

25.26

2.11

-19.28

3.

Synth. UIS SPXL/TMF 2002 - 2015

44.78

33.59

1.33

-43.95

4

Synth. UIS SPXL/TMF 2002 - 2015
(same parameter as 2)

35.72

32.65

1.09

-48.97

5

SPY 2002 - 2015

8.92

19.36

0.461

-55.19

6

TLT 2002 - 2015

7.81

13.84

0.56

-26.58

7

SPXL Jul 2009 - 2015

44.17

47.69

0.93

-53.82

8

TMF Jul 2009 - 2015

20.04

45.88

0.44

-53.33

9

Synth. SPXL 2002 - 2015

15.93

56.81

0.28

-94.18

10

Synth. TMF 2002 - 2015

16.39

42.15

0.39

-66.39

Before we analyze the outcome of the backtests in detail, note the maximum drawdown of -94% (-66.39%) in the synthetic SPXL from October 2008 to March 2009. In practical terms, $100 invested in SPXL during this period would have decreased to $6, we estimate only few people on this planet would have gone through this roller-coaster without de-leveraging, thus with the retrospective knowledge that the world did not 'go bust', losing a major part of their account.

That said, it is also clear that any leveraged strategy with fixed (not adaptive) allocation ratios would not survive a 2008 crash. It is just an absolute necessity to reduce the stock market allocation if you go through a longer market correction. Unfortunately these 3x leveraged ETFs have all been issued after the 2008 crash. Since then we had a continuous bull market which makes any post-2009 backtest look really attractive.

There is a notable different behavior of the strategy before and after the financial crisis in 2008/09, which is visible in the chart. Only after the 2008 correction investors seem to really see Treasuries as a safe haven asset which goes up when the stock market goes down. Since 2008 the average correlation between the stock market and Treasuries was about -0.5. Before 2008 the average correlation was around 0.

Parameter stability of the 3x leveraged UIS in the extended 2002 - 2015 period

Our algorithm optimizes for the 'modified Sharpe Ratio', so we plot this instead of the regular Sharpe Ratio, together with the Annual Return CAGR and volatility with the horizontal axis representing our f factor, and the vertical axis the lookback period.

You can see that both the annual return and volatility are very stable across the parameter range, with values going from 39%-45% annual return, and 32%-34% annualized volatility - even our heatmap plot goes aggressively from 'very green' to 'very red' in these close ranges.

Portfolio options using the 3 times leveraged UIS - Calming the 'Fire in Hell'

As we stated in the beginning, this "Hell on fire" strategy might look excessively aggressive to many private investors due to the 3 times leverage resulting in relatively high volatility. So why do we present this here? Well, we see this strategy as a very good complement even to conservative or moderately growth seeking portfolios.

Here are two examples of how this strategy might be blended with other Strategies: We combine 'Hell on fire" with two other strategies we had previously introduced in SeekingAlpha: The "Sleep Well Bond Rotation" and the "Maximum Yield Rotation" Strategies.

The first Portfolio of Strategies ("Custom Portfolio") seeks maximum annual return with a maximum Volatility of 20%, so suited for investors looking for rather aggressive growth:

You can observe that by allocating 23% to the 3x UIS, this portfolio delivered a very aggressive 45% annual return, but backed up by a dream Sharpe Ratio of 2.2.

The second Portfolio option ("Custom Portfolio 1") also seeks maximum Annual Return, but this time with a maximum Volatility of 10%, better suited for investors who seek moderate growth or require a low volatility portfolio with stable returns due to having reached the retirement age:

In this portfolio we observe that by just allocating 5% to the 3x UIS, we achieved a very good 23% annual return, with an even higher Sharpe Ratio of above 2.3.

Plotting the custom portfolios together with the different strategies on a Risk / Return chart:

It is easy to observe how these blends of strategies deliver dramatically better results than what would ever be possible by using any combination of some common market proxies like Short and Long Term Treasuries, Bonds, US Equities and Gold we included in the plot chart.

Yet the same 'power of diversification' like in conventional asset allocation still applies: Using a blend of a Bond Rotation Strategy, an Equity Rotation Strategy like the Global Market Rotation Strategy, and as additional diversification some inverse volatility and treasuries stemming from the Maximum Yield Rotation Strategy we achieve results which again drastically outperform each individual strategy performance. Using this blend of strategies also enables us to configure virtually all possible portfolios targets, be it constraining volatility, classically optimizing for Sharpe Ratio or setting minimum or maximum weights by asset class.

Part II of this article will look at the same strategy, but executed with the inverse -3x leveraged ETFs SPXS and TMV.

Disclosure: The author is long TMF, SPXL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.