Can we beat S&P 500 index only using ETPs with smaller drawdowns? I believe the answer is YES if you allocate your assets properly. Asset allocation is the most important thing in investing, even more important than stock picking.
For the little guy's portfolio, we have decided to use a "dynamic asset allocation" strategy (DAAL). The principle is very simple: the assets will be allocated to four ETPs, $SSO, $UST, $XIV or $VXX. Simple trend following rules will be implemented to decide which ETP will be held in the portfolio. We will not use explicit leverage, but implicit leverage has already been built in these ETPs. SSO and UST are 2X daily long ETFs of SPY and BND respectively, so their volatilities are exactly twice of SPY or BND. VXX and XIV, have ~4 times of realized volatilities than SPY during the past a few years. The trend following method will help reducing the drawdowns of the method while preserving most of the "horsepowers" from the ETPs as I will show below.
If $1,000 was invested using our strategy on January 1, 2005, it would have grown to $27,361 on December 19, 2014 during a 10 year period (Fig. 1). The annual return is 39% and readily beats the performance of buy and hold SPY strategy that has an annual return of 7.7% with an ending value of $2,088. This impressive return was achieved with smaller maximum draw down (% peak-to-trough decline) comparing to SPY. The max draw down for DAAL is 41% comparing to 55% for SPY (Fig. 2). Note that the day-to-day volatility for the DAAL strategy is higher than SPY. There are five instances that DAAL had drawdowns greater than 30% (including the current 10/2014 - 12/2014 period). In all instances except the 2007-2008 drawdown, the strategy recovered to a new high within seven months. The 2007-2008 drawdown lasted 18 months. The SPY strategy, on the other hand, had a large drawdown in 2007-2012 that lasted almost 5 years.
Figure 1. Growth of $1,000 from 1/1/2005 to 12/19/2014 using DAAL or buy and hold SPY
Figure 2. Drawdowns of DAAL and buy and hold SPY strategies 1/1/2005-12/19/2014
In conclusion, I expect that the DAAL strategy will continue beating S&P500 during the next 10 years by a large margin. What will be critical for us is our commitment to carry out the strategy PERSISTENTLY, especially in bad times (I am certain it will come sooner than later with higher interest rate expected starting second half of 2015). We need to learn having a long term perspective and ignore the short term volatility. Happy investing!
Disclosure: The author is long XIV, SSO.