The Trading Strategy That Beat The S&P 500 By 16+ Percentage Points Per Year Since 1928

Dec. 04, 2018 11:30 AM ETTLT, UPRO, TQQQ536 Comments92 Likes
Logan Kane profile picture
Logan Kane


  • The media loves to warn about the perils of holding 2x and 3x ETFs overnight. In the past, I too have been a vocal critic of certain leveraged ETFs.
  • After analyzing quantitative data on index leveraged ETFs, I found that they are severely misunderstood as trading instruments.
  • While they aren't suitable for many investors, everyone should understand the true risks and rewards of leveraged ETFs.
  • I'd also like to introduce a trend-following strategy that has shown significant alpha/excess returns when paired with leveraged S&P 500 and Nasdaq 100 ETFs.
  • The most widely studied implementation of the strategy beats the S&P 500 by an astonishing 16 percentage points per year.

Texas is famous for its tradition of risk-taking. Everything is bigger and bolder here. When Jerry Jones makes the commute from his house in Highland Park to AT&T Stadium to watch the Cowboys play, he doesn't take a car or a limo. He takes his helicopter. That's the Texas way.

I don't know if Jerry Jones likes to trade stocks or not, but I have found an intriguing strategy with a lot of alpha and a commensurate level of risk. If you have some money to play with and you're looking for the ultimate long and leveraged trade, I think I've found it. Try to read this article with an open mind and decide for yourself!

Laying the groundwork

Leveraged ETFs are vilified by the media for being instruments of massive wealth destruction. I've been a critic of leveraged ETFs in the past for many of the same reasons that the media at large has been critical.

The most popular warning tossed around in the media is that by doubling or tripling the daily return of the index (leveraged ETFs rebalance daily), you inevitably lose money to slippage/volatility drag.

For example, if one day the index goes down 10 percent and goes up 10 percent the next day, you haven't made your money back. Instead, for every 100 dollars you invested, you would lose 10 dollars the first day and make back 9 the second day. If you leveraged 3x the daily return, you would theoretically be down 30 percent on the first day and only up 21 percent the second day.

The media isn't entirely off-base with their criticism of leveraged products.

There are a lot of rigged products in the leveraged ETF space (everything tied to commodities, volatility products or short an index is inherently rigged against you), so you have to either follow the script or know what you're doing if you want to trade these instruments. The only tradable leveraged ETFs are the ones that track indexes with 2 or 3 times leverage.

When you look at the long-term returns from leveraged long-equity ETFs like 3x S&P 500 (UPRO) or 3x Nasdaq (TQQQ), you see that their returns don't support the "you're going to lose all your money hypothesis".

ChartSPY data by YCharts

If you'd invested, say, $10,000 dollars in TQQQ with the understanding that you'd cash out when you had enough for a $250,000 down payment for a house, you would have been able to do it in less than 8 years. Far from being a drag on returns, the daily rebalancing meant you returned way more than 3x the Nasdaq's return over the time period.

In fact, you would have returned close to ten times the return of the unleveraged Nasdaq. Every day the Nasdaq went up, the fund's leverage ratio would go down and the fund could buy more QQQ. UPRO works the same way, except with the S&P 500.

By releveraging to 3x every day, UPRO and TQQQ exponentially vacuum up more and more assets over time.

Here's an example of the exponential acceleration that leverage provided to S&P 500 investors since 1928 (being able to include the Great Depression is helpful for backtests as the Nasdaq did not yet exist).

Source: Pension Partners

Leverage increases return but also introduce a lot of path dependence to your net worth. If the market goes up, you look like a genius. If the market goes down, everyone (your spouse) thinks you're an idiot.

In a trending market, this leveraging mechanism can make your wildest dreams come true. In a down market, leveraged ETFs are forced to sell assets at low prices.

The interaction between leverage being an accelerator of returns and a drag can be mathematically explained, however.

In fact, I've found a couple of award-winning quant papers on daily leveraged strategies that when put together with some unrelated research can generate large amounts of alpha. Surprisingly, they've been downloaded less than 6,000 times each on SSRN.

It turns out that expected volatility is easier to forecast than stock returns. We'll get to it in a little, but this is where the alpha comes from. Since volatility drag has such an effect on the returns of leveraged ETFs, it's a somewhat of a free lunch to target a reduction in volatility.

Understanding volatility drag

The first paper is called "Alpha Generation and Risk Smoothing Using Managed Volatility," by a guy named Tony Cooper. They have a huge dataset of historical market performances which is extremely helpful for designing these kinds of strategies. They use a complicated volatility targeting strategy to create alpha, but I found a simpler one that I like better.

Source: Double-Digit Numerics

Source: Double-Digit Numerics

As you can see from the graphs, there's a quadratic relationship between leverage and compounded annual returns.

If you use a little leverage, you increase your returns. If you use too much leverage, however, your returns actually start to go down as the amount of risk you take overwhelms your return, forcing you to sell too much at low prices during drawdowns (or risk losing all your money). There are two factors in play here.

1. In a trending market, leverage allows you to "pyramid" your positions. As your collateral increases in value each day, you use it to take out additional margin to buy more stock. This exponentially increases your returns.

2. In a down or volatile market, leverage forces you to sell at low prices (or risk blowing up your account). This exponentially decreases your returns.

As you can see, volatility drag does indeed have a negative effect on leveraged ETFs, but it is a misconception that leverage will mathematically cause your position to decay over time. In fact, we see the opposite effect at reasonable levels of leverage. Another driver that affects returns is the LIBOR, as most of these ETFs are using LIBOR for S&P 500/Nasdaq swaps to reduce their transaction costs. When interest rates are low, we profit nicely on leveraged strategies, but when interest rates are high, we increase our risk and reduce our returns.

Note that if you keep increasing leverage beyond the point of maximum return, your CAGR eventually goes sharply negative (For example, 5x leverage would have wiped you out during the infamous 1987 crash when the S&P fell 20.4 percent). After the 1987 crash, regulators put marketwide circuit breakers to briefly shut down the markets in cases of large imbalances and to shut down the stock exchange for the day if the S&P falls 20 percent at any point during a trading session. The stock exchange actually never opened on the morning of the 9/11 attack, but the circuit breaker would have been in effect as a backstop if needed.

The trick is to find the "Goldilocks point" where you aren't using too much or too little daily leverage. This point has usually been 2x to 3x in various time periods and equity markets. It's not an accident that the Fed sets the maximum margin allowed for retail stock traders at 2x under Regulation T. 3x works even better if you are willing to cut positions in a downtrend and releverage once they start to go back up, but most retail traders are psychologically unable to do this.

Understanding what the true risks are with leveraged ETFs is important. UPRO and TQQQ are tools that can help you achieve your goals, but are also very capable of seeing 90-95 percent drawdowns. Another issue is that leveraged ETFs don't create any alpha by themselves.

If you buy and hold these instruments, you're just taking more risk and getting a corresponding return. However, by studying the statistics of volatility and returns, I found some odd patterns that generate significant amounts of alpha.

The trend is your friend

On any given day, the odds of the market going up or down are not 50/50. Additionally, stock returns do not follow a normal distribution, as is commonly assumed in many models. On any given day, the market has roughly a 53 percent chance of rising. The odds of the market rising over longer periods increases continually as the time period you're looking at increases. Daily market returns are also streaky. You are statistically more likely to have multi-day winning streaks during uptrends. This plays into our hands.

Total stock market returns are notoriously hard to forecast. However, volatility is relatively easy to forecast.

In particular, volatility today is correlated with volatility tomorrow. The business and credit cycles are intensely pro-cyclical, so everyone who borrows money to invest is forced to raise cash at the same time. We can use some basic game theory to know when banks and hedge funds are likely to get in trouble based on volatility, then wait in cash or US Treasuries to pick up the pieces.

The first paper used complicated volatility targeting measures to reduce risk. It works, but I think it's overkill.

Another award-winning paper I found is called "Leverage for the long run," and uses the 200-day moving average to forecast volatility.

The 200-day moving average method works shockingly well. We already know that 3x leveraged ETFs tend to do even better than 3x the market in low volatility markets and worse in high volatility markets. The trick to pocketing the extra return is to isolate the periods when volatility is most likely to occur.

Source: Leverage for the Long Run

This is an amazing split. Volatility is almost twice as high when stocks are below their 200-day moving average than when they're above it.

This indeed allows us to isolate the instances when we are most likely to experience significant market declines and the times when 3x leverage is most likely to underperform the index due to volatility drag.

By doing this, you also are able to identify environments when market crashes are more likely to occur. As you can see, over two-thirds of the worst trading days for the market occur when the S&P 500 is trading below its 200-day moving average.

Source: Leverage for the Long Run

The 200-day moving average isn't just something recently cooked up, either. The idea of only owning stocks above the 200-day moving average has been around for a long time. Nobel prize-winning professor Jeremy Siegel covered the strategy in his book Stocks for the Long Run but ultimately concluded that the strategy returned less than buy-and-hold, albeit with less risk.

However, the increased effect of volatility drag on leveraged ETFs (and acceleration of returns in calm markets) flips the script on this assumption.

The "Leverage for the Long Run" strategy

The moving average strategy proposed in the Pension Partners paper is pretty simple. As long as the S&P 500 is above its 200-day moving average, buy and hold UPRO. When the S&P 500 sinks below its 200-day moving average, rotate to cash.

The tab on the right is what their strategy returned in the backtest, which includes the Great Depression and Global Financial Crisis of 2007-2009.

Source: Leverage for the Long Run

In all, their leveraged ETF strategy on the S&P 500 has a positive alpha of 16 percent per year. Here's how often the strategy would have traded over the past 18 years.

ChartSPY data by YCharts

You'd have avoided almost the entirety of the bear markets in 2000-2002 and 2007-2009 while catching the upside with 3x leverage. Valuations and growth do matter for this strategy as we can explain roughly 20 percent of the variation in future stock returns by valuation alone (typically the r-squared, a statistical measure of how much of y you can explain by x, is around 0.20), so going forward the optimal index to apply leverage to may not be the same. However, the trend following system really does work.

Improvements to the strategy

Academic research shows that momentum strategies tend to outperform the market at large. Adding leveraged ETFs to the momentum factor is like pouring gasoline on the fire to returns of the 200-day moving average strategy. I feel that the simplest improvement to the trend following strategy is to use the Nasdaq rather than the S&P 500, as seen by the performance over time.

The Nasdaq has outperformed the S&P 500 in roughly 60 percent of quarters going back to 1986 and has a stronger exposure to the momentum factor. You can see in the first graph above how much of a difference this has made.

Additionally, instead of investing in cash instruments when the index is below the 200-day average, I'd think about rotating into long-term Treasury bonds (TLT) to take advantage of periods of risk aversion. We know that markets tend to see most of their worst days when stocks are below their 200-day average, and also that Treasuries tend to catch a bid as investors flee risky assets in downturns. This strategy would have significantly helped your returns in 2008.

Additionally, I recommend a 1 percent band around the 200-day average to prevent being whipsawed as the market hovers near its 200-day average. Let it close 1 to 1.25 percent below before you sell and wait for it to go 1 percent above before you buy. Additionally, you may want to consider using the 150 or 175-day averages as they're less popular with traders. 200-day moving average traders are still smart money, but the fewer people you have selling when you want to sell and vice versa when you buy, the better. I'd use the moving average on the S&P even though we're trading the Nasdaq as it's a volatility forecaster, not a market timing model.


I recommend that investors who wish to participate in these kinds of strategies to set up a separate account for trading (you'll have three accounts if you also have a retirement account). This type of separation has been studied to help you achieve better results in both your long-term investments and short-term trading.

Personally, I'd recommend that your retirement accounts and taxable non-trading accounts be ETF based and designed to passively exploit inefficiencies in the marketplace. See part one and two of my ETF series on this here (part two is more in-depth and optimized). Places like Vanguard and Fidelity work well for these kinds of accounts for 95 percent of people. If you want to run more of a risk-parity strategy for your taxable accounts you'd probably need an Interactive Brokers account.

Then, in a separate account, you have your trading account. In your trading account, you take individual stock positions and/or can run systems like this leveraged ETF strategy. For this account, the only thing that matters is that commissions/trading costs are low and it's at a different brokerage than your main stuff so you're not tempted to move funds between your alpha strategies and your long-term investments too often.

High-beta strategies have the potential to help you achieve your goals. Of particular interest is the fact that having 33 percent of your portfolio in 3x leveraged TQQQ has massively outperformed being 100 percent long QQQ since 2010. While I think that the leveraged strategy should be run on the side rather than in your main portfolio, this anomaly warrants further investigation.

Who is this leveraged ETF strategy appropriate for?

This strategy is most appropriate for investors in their 20s, 30s, and 40s who are comfortable taking a lot of risks. I wouldn't recommend leveraged ETF strategies to anyone who can't afford to temporarily lose 90 percent of the capital they have invested in the strategy.

However, if you're straight out of college with a 100k per year job and have either few assets or significant debt to pay off, this strategy can work wonders. Even a buy-and-hold TQQQ strategy has the potential to pay off things like mortgages and student loans in short order if the market cooperates for just 3-5 years. If you're young, you can always reload cash into the strategy if it sees a significant drawdown to profit on the following upswing.

The best way to use high-beta strategies like this is to set a goal for how much money you want to have for something and cash in once the market takes you there. Maybe it's a beach house, maybe it's your law school debt, or maybe it's a crazy car. Just pick something.

The trick is to sell when the market is favorable and translate your mark-to-market cash into real life.

Lastly, I'd recommend starting a strategy like this a no more than 10-15 percent of your net worth if you have an established portfolio. Additionally, if the strategy does well, consider diversifying or spending some of the cash you're making once it gets over 35-40 percent of your net worth. That said, If you're 23 and investing your first bonus, then you can fire away and not worry about the allocation yet.

In conclusion, trend following with leveraged ETFs will help the right person find a shortcut to achieve their goals if used properly.

Additionally, make sure to check that the SPY is above its 200-day moving average when you're reading this. If it isn't, then hold off on executing this trade.

Did you enjoy this article? You read the whole thing, so go ahead and follow me!

This article was written by

Logan Kane profile picture
Author and entrepreneur. My articles typically cover portfolio strategy, value investing, and behavioral finance. I like to profit from the biases and constraints of other investors.

Disclosure: I am/we are long QQQ, 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.

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.