Could leveraged ETFs withstand volatile markets better?

A portfolio of leveraged ETFs provides an attractive alternative to traditional 60-40 allocations, suggests research

Could leveraged ETFs withstand volatile markets better?

While the recent increased interest in leveraged and inverse ETFs might smack of extreme risk-taking among return-hungry investors, new research suggests that if used correctly, the strategies could actually provide good results.

In a paper published last week, Mikhail Smirnov from Columbia University said a portfolio of leveraged ETFs he first proposed in 2017 showed attractive risk-adjusted returns relative to both a classic 60-40 balanced stock-bond portfolio and a stock index, reported Institutional Investor.

“After the coronavirus crisis, we see that balanced portfolios suggested in 2017 sustained the crisis very well and performed well in 2020,” Smirnov said.

He said the aggressive hypothetical portfolio – which included a 40% investment in a triple-leveraged Nasdaq 100 ETF, 20% in an ETF with triple-leveraged long index exposure to U.S. government bonds, and 40% in a single-leveraged long U.S. government bonds index ETF – performed well in 2018, and also through the coronavirus crisis up to mid-January 2021.

He compared the portfolio’s performance with that of a 60-40 stock-bond mix held through two Vanguard-managed mutual funds, as well as a holding with a higher bond allocation that was 20% levered at the portfolio level. In his analysis, the portfolios were rebalanced monthly.

He found that from the start of 1986 to January 15, the traditional portfolio returned 9.5% annually, trailing the 10.6% generated by the leveraged portfolio of stock and bond funds over the same period. He also found that the portfolio’s “120 percent leveraged cousin,” which had an allocation of 72% in bonds and 48% in stocks, matched the S&P 500’s returns, but with lower volatility and drawdowns.

Looking at the more recent performance of his 2017 hypothetical 40-20-40 leveraged ETF portfolio, he found that it returned 27.2% in the five years through 2017; extending the endpoint to mid-January resulted in greater returns, with annualized gains reaching 32%.

Backtesting the leveraged ETF portfolio’s performance with that of State Street Global Advisors’ SPDR S&P 500 ETF Trust (SPY) from August 12, 2005 until January 15, he found the leveraged portfolio earned a total return of 24.5%, beating the S&P 500 tracker’s 9.7%. And while his portfolio suffered greater annual volatility, it had a marginally better maximum drawdown of 51.5% compared to 55.2% for SPY.

“Leveraged ETFs provide a convenient mechanism to dynamically change portfolio exposure and can be successfully used to construct robust portfolios that perform well during equity market drops,” Smirnov said.


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