My strategy relies on a risk parity allocation of leveraged stocks (3x the S&P 500 index via UPRO) and leveraged long-term treasury bonds (3x the ICE U.S. Treasury 20+ Year Bond Index via TMF). This concept is based on Modern Portfolio Theory (MPT) of improving risk-adjusted return over long periods by holding uncorrelated assets, such as a traditional 60/40 stocks/bonds portfolio to find the efficient frontier, and then applying 3x leverage from there on to beat a 100% stock portfolio via leveraged ETF's to overcome the fact that no broker here trusts me with cheap margin.
Risk parity is a portfolio allocation strategy in which risk is spread evenly among assets within the portfolio by looking at the volatility contributed by each asset, thereby attempting to optimize returns per unit of risk (Sharpe Ratio). Risk parity for this asset allocation is optimized at roughly 40% UPRO / 60% TMF. I am a apebrained degenerate so I moved it to 50/50. Rebalancing is done on a quarterly basis for simplicity, but can be done with bands, annually, etc.
The strategy relies heavily on the negative correlation (or at least, uncorrelation) between stocks and long-term treasury bonds, wherein the bonds provide a buffer during stock drawdowns. Long-term treasuries are chosen precisely because they are more volatile than shorter-duration bonds and because of their higher degree of negative correlation to stocks compared to corporate bonds, in order to sufficiently counteract the downward movement of a 3x leveraged stocks position in a crash.
Intrinsically, we're relying on US stocks and long-term treasuries not crashing in tandem, which is rare (albiet still a material risk). At the time of writing, these assets have a seemingly reliably negative correlation close to -0.5 on average. A key fundamental assumption of this strategy is that the US will not return to pre-Volcker (pre-1982) monetary policy. That is, we'll be able to significantly mitigate or altogether avoid runaway inflation periods like the late 1970's, during which time bonds suffered greatly. Will the recent QE tapering increase the risk of this occuring? Who knows, but I wouldn't bet against the fed.
So why long term treasuries?
- We know that treasury bonds are an objectively superior diversifier alongside stocks compared to corporate bonds. This is also why I don't use the popular total bond market fund BND. It has been noted that this greater degree of uncorrelation between treasury bonds and stocks is conveniently amplified during periods of market turmoil, which researchers referred to as crisis alpha.
- Again, remember we need and want the greater volatility of long-term bonds so that they can more effectively counteract the downward movement of stocks, which are riskier and more volatile than bonds. We're using them to reduce the portfolio's volatility and risk. More volatile assets make better diversifiers. Most of the portfolio's risk is still being contributed by stocks.
- This one's probably the most important. We're not talking about bonds held in isolation, which would probably be a bad investment right now. We're talking about them in the context of a diversified portfolio alongside stocks, for which they are still the usual flight-to-safety asset during stock downturns. Specifically, for this strategy, the purpose of the bonds side is purely as an insurance parachute in the event of a stock crash. Though they provided a major boost to this strategy's returns over the last 40 years while interest rates were dropping, we're not really expecting any real returns from the bonds side going forward, and we're intrinsically assuming that the stocks side is the primary driver of the strategy's returns. Even if rising rates mean bonds are a comparatively worse diversifier (for stocks) in terms of future expected returns during that period does not mean they are not still the best diversifier to use.
- Similarly, short-term decreases in bond prices do not mean the bonds are not still doing their job of buffering stock downturns. Vice-versa, historically when treasury bonds moved in the same direction as stocks, it was usually up. Bond convexity means the overall risk-return profile of the portfolio is asymmetric and favors the upside.
- Again, I acknowledge that post-Volcker monetary policy, resulting in falling interest rates, has driven the particularly stellar returns of the raging bond bull market since 1982, but I also think the Fed and U.S. monetary policy are fundamentally different since the Volcker era, likely allowing us to altogether avoid runaway inflation environments like the late 1970's going forward (money printer go brrrrt). Bond prices already have expected inflation priced in. Everything is fucking priced in.