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 a 3x leveraged S&P 500 ETF?
1. You avoid the volatility drag from international equity indexes or even large-cap exclusive indexes like the NASDAQ 100. Holding the largest basket of mid-large cap American ETF's offers the best base risk-return profile before adding in a long treasury positon.
2. Circuit breakers (7, 13, & 20%) for the S&P 500 which either pause or halt trading following major intraday losses. This somewhat mitigates the possbility of your 3x leveraged ETF losing 100% following a 33.4% drop in the underlying index and getting liquidated. The same circuit breakers are not present for the NASDAQ 100.
3. 40-55% UPRO seems to be optimal as any larger allocations create the possibility of deep drawdowns that would take years to recover from. If you wanted to for some reason, you could also use the slightly more expensive SPXL instead of UPRO. Their liquidity and performance should be nearly identical.