Leveraged ETFs For Long-Term Investing

Summary

• Market history has shown that an allocation to bonds can diversify and lower the risk of an equity portfolio.
• However, since bond returns have historically lagged equities, an allocation of investor capital to bonds has also lowered overall portfolio returns.
• Leveraged ETFs can allow investors to maintain their desired equity allocation while freeing up capital for bonds.
• We investigate historic returns on leveraged equity and bond portfolios and find that 100% SPY + bond portfolios have had higher total returns with lower beta and drawdowns.
• While the last decade has favored a leveraged equity and bond allocation, we think that forward returns are unlikely to match those of the recent past.
• This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »

Note: this article was originally released several weeks ago.

The S&P 500 index is probably the most frequently used market benchmark in the world and many investors, particularly those who operate within equities, compare their investment results to this index. And as many investors have found out, outperforming this index in any sustainable fashion is difficult.

One way to avoid underperforming the S&P 500 is to allocate one's full capital to an ETF like SPY that tracks the index which will try to get as close to the performance of the index as is operationally feasible for a small fee. While this investment approach will avoid the disappointment of underperformance, it suffers from two drawbacks. First, it leaves no capital for any other investment opportunities and secondly, it generates a relatively paltry income stream.

A way to address these two drawbacks while maintaining equity exposure to the S&P 500 is to utilize leveraged ETFs that track the same index while putting the rest of the capital into fixed-income ETFs. This type of investment portfolio typically not only achieves the full desired equity exposure but also holds the promise of 1) outperformance and alpha generation, 2) diversification and a decrease in the beta of the portfolio and 3) increase of portfolio income.

In this article we review this investment strategy of pairing leveraged equity with fixed-income ETFs, how this strategy has fared over the past decade and our views about its future performance.

Our key takeaways are that first, high-quality, long-duration fixed-income investments have proven to be good complements to stocks. Secondly, pairing bond ETFs with leveraged equity funds has historically delivered higher absolute and risk-adjusted returns. And thirdly, at this stage in the investment cycle leveraged equity and fixed-income portfolios are not as attractive as they have been previously, owing to higher leverage costs as well as

Analyst’s Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.