The battle of the leveraged portfolios competition, between 10 different portfolios, opened my eyes to the potential pros and cons of leverage in ways I could have never imagined.
I came into the competition thinking that diversified portfolios that included an alternative sleeve would thrive with modest leverage but would eventually fall apart with aggressive leverage.
On the other hand, I had the belief that portfolios featuring merely stocks and bonds would fall apart rather quickly when leverage was applied at even modest levels.
Maybe only the 20/80 portfolio would survive.
I was wrong about both.
In fact, there was so many different things that I learned from Picture Perfect Portfolios challenge that I’ve decided to wrap up the series with 10 key takeaways from the portfolios challenge.
- Picture Perfect Portfolios Challenge: Battle Of The Leverages Portfolios Introduction
- Picture Perfect Portfolios Challenge: Battle Of The Leverages Portfolios No Leverage (100% Canvas)
- Picture Perfect Portfolios Challenge: Battle Of The Leverages Portfolios 2X Leverage (200% Canvas)
- Picture Perfect Portfolios Challenge: Battle Of The Leverages Portfolios 3X Leverage (300% Canvas)
- Picture Perfect Portfolios Challenge: Battle Of The Leverages Portfolios 4X Leverage (400% Canvas)
10 Things Learned from the Leveraged Portfolios Battle
Hey guys! Here is the part where I mention I’m a travel vlogger! This Battle of the Leveraged Portfolios series is entirely for entertainment purposes only. Most investors should not use leverage. There could be considerable errors in the data I gathered. This is not financial advice. Do your own due diligence and research. Consult with a financial advisor.
1) Portfolio Balance Is Crucial
When it comes to building portfolios that are prepared for every economic curveball thrown their way allocating assets in a balanced manner is crucial.
The portfolios that underachieved the most in this challenge (namely the 80/20 and 20/80) were the most lopsided.
The Growth 80/20 Portfolio was only able to achieve 1.5X leverage for each and every round of the games due to the “worst year” clause being triggered.
For those who didn’t follow closely, our benchmark for the challenge was the US Total Stock Market, and portfolios were not allowed to have a year worse than -37.04%.
The 80/20 portfolio, given that most of its risk is concentrated in equities (which are a volatile asset class) not surprisingly was the worst performer in the challenge at each and every level of leverage in the competition.
However, I was most surprised by the 20/80 portfolio relatively struggling, at every level of the competition, that I’m including an entire section on its failures as a portfolio.
2) Income 20/80 Portfolio Should Be Retired
The biggest “jaw dropping” surprise for me of the entire leveraged portfolio competition was just how bad the 20/80 portfolio did from a returns meets risk standpoint at each and every level of the games.
Firstly, the 20/80 portfolio never achieved a level of return (CAGR) that was higher than its risk (standard deviation).
That was true for both the unleveraged, 2X, 3X and 4X competition.
Every other portfolio that reduced its equities to less than 60% and featured an alternative sleeve had a CAGR that was always higher than its level of RISK.
A true nail in its coffin was the fact that the 40/60, Risk Parity Portfolio, Ray Dalio All-Weather Portfolio and the Permanent Portfolio all had better performance from a worst year perspective.
Going back to point #1 achieving balance with a portfolio was the key to succeeding in the games from a returns meets risk standpoint.
Shaving off 10 to 20% from bonds and adding more equities, gold and/or cash (which would have put it closer in alignment to the Ray Dalio All Weather Portfolio, Risk Parity Portfolio and the Permanent Portfolio) would have greatly improved the risk adjusted returns of this portfolio.
Hence, the only reason this ultra-conservative portfolio exists is to manage volatility and it underforms all of the alternative sleeve portfolios and even the 40/60 from a Sharpe ratio, Sortino ratio and worst year perspective.
Thus, it’s time in my opinion to say ciao to this portfolio permanently.
RIP 20/80.
3) Alternative Sleeve = Success with Aggressive Leverage
What became readily apparently, as soon as leverage was applied to portfolios, was that any portfolio featuring an allocation an “alternative sleeve” which in this case meant gold/cash enhanced risk adjusted rates of returns.
What do I mean by that specifically?
In other words, portfolios that were balanced in nature between stocks, bonds and alternatives featured returns (CAGR) that exceeded the level of risk (Standard Deviation).
As more leverage was applied, the gap between the CAGR and RISK level increased (not decreased) meaning that Sharpe ratios and Sortino ratios continued to be enhanced.
At the 2X leverage level every single one of these portfolios thrived including the Nomadic Samuel portfolio that featured equal parts equities and bonds along with a small allocation to alternatives (gold).
When aggressive leverage was applied, portfolios that featured something closer to 2 parts bonds to 1 part stocks (or an additional uncorrelated asset class such as cash) handled the burden of massively dialed up leverage with ease.
The worst year for these portfolios, even with 3X leverage, was considerably better than a 100% stock only portfolio or 80/20 portfolio.
Even more impressive was that the balanced portfolios (Risk Parity, Ray Dalio All Weather, Permanent Portfolio) never had a sequence of returns period (low roll period) of anything worse than just one negative year.
There was no three year or five year roll period of negative returns (such as with the 60/40 portfolio) or entire lost decades of negative returns (such as with the 80/20 or 100% equities portfolios).
These portfolios could handle aggressive leverage like a pack mule.
They just kept going without showing signs of concern.
4) Low Roll Period: Sequence Of Returns Risk
The most fascinating aspect of the battle of the leveraged portfolios was the low roll period returns.
In other words, the worst potential sequence of returns risk for each of the portfolios from a 1 year, 3 year, 5 year, 7 year and 10 year perspective.
-1 Year: Risk Parity, Ray Dalio All-Weather, Permanent Portfolio, Nomadic Samuel Risk Parity Portfolio
-3 Year: 40/60 Portfolio, 20/80 Portfolio, Nomadic Samuel Portfolio
-5 Year: 60/40 Portfolio
-10 Year: 80/20 Portfolio, 100% Equity Portfolio
As you can see the portfolios that only experienced a worse case scenario sequence of returns of negative 1 year roll period were the most balanced and economic regime ready: Risk Parity, Permanent Portfolio and Ray Dalio All-Weather Portfolio.
The next tier of success was the equity/bond combinations of 40/60 portfolio and 20/80 portfolio along with the Nomadic Samuel Portfolio (equal parts equities/bonds and a sliver of a gold).
The 60/40 portfolio had the potential for a negative five year period.
The 80/20 and 100% equity only (even without leverage) could have meant investors were below water for an entire decade.
Hence, for investors thinking of putting together an optimal portfolio for a risk meets returns standpoint and a sequence of returns standpoint (prepared for all economic regimes) a balanced approach to equities, bonds and alternatives is the only way to go.
Not a single portfolio that was missing an alternative sleeve had better than a negative three year sequence of returns risk.
Alternatives were mandatory (not optional) if you wanted to upgrade to only a 1 negative year sequence of returns risk.
5) 60/40 Portfolio Is Not Optimal For Aggressive Leverage
Not surprisingly, at least for me, was that the leveraged 60/40 portfolio was anything but the “best” in terms of the leverage challenge.
In fact, the 60/40 portfolio had its weaknesses on full display given that it reached a level of 20 volatility with just 1.9X leverage and could only approach 2.7X leverage before it had a year worse than a 100% equity only portfolio (-37.04%).
Thus, a sensible application of leverage to the most “common portfolio” industry-wide would be “modest” at 1.5 to 1.9X.
Anything beyond that, in terms of aggressive leverage, should warrant a equity/bond portfolio to shift towards a 50/50 or 40/60 allocation.
Currently, products being offered reflect that in the marketplace.
For instance, the 90/60 WisdomTree 1.5X 60/40 portfolio hits its sweet spot target where returns and risk should allow it to outperform equity only mandates while creating space in the portfolio for something else.
Pimco StockPlus being at 100/100 (50/50 split) is better prepared as leverage is dialed up.
For those seeking beyond a 200% canvas it makes sense to go 40/60 as we’ll discover below.
6) 40/60 Portfolio Was The Stock/Bond Winner
In terms of risk adjusted returns, at all levels of leverage, the 40/60 portfolio was the clear winner of the equity/bond only combinations.
This was the only portfolio that could hang with the Risk Parity, Ray Dalio All-Weather and Permanent Portfolio at aggressive leverage levels.
Yet, at the 3X and 4X level of leverage it became apparent that not having an alternative sleeve was a serious weakness relative to the other portfolios that offered such coverage.
7) Risk Parity + Ray Dalio All Weather + Permanent Portfolio = Overall Winners
When it comes to the winners of the classic portfolios being trotted out for the games it was the Risk Parity Portfolio, Ray Dalio All Weather Portfolio and the Permanent Portfolio came in as a the clear winners.
In every round of the games they were able to reach the full leverage mandate without succumbing to any of the volatility or worst year constraints that trapped the 80/20, 60/40 and 100% equity portfolios.
Furthermore, as leverage was dialed up in each round these portfolios increased the spread between the CAGR (returns) versus RISK (standard deviation).
Things just kept getting better and better.
The only area of concern had to do with a worst year scenario.
Increasing leverage caused each of these portfolios to reach double digit negative years eventually.
But none of these portfolios came close to having a negative year as bad as a 100% equity portfolio (even when reaching insane levels of leverage such as the 4X competition).
Thus, investors seeking the ultimate returns meets risk efficient frontier can confidently leverage any one of these three portfolios at around the 200% canvas level to beat a 100% only equity mandates with ease (in terms of returns) while also managing volatility and sequence of returns risk as well.
No lost decades over here; at worst just a bad year.
Why so many in the industry encourage young investors to be in 100% equity only portfolios when a sensible application of leverage towards a balanced stocks/bond/alternatives portfolio could provide the returns (plus risk management) they’re seeking is certifiably insane.
8) The Best Portfolio For Every Round Of The Games
In terms of the best portfolio for each round of the games I came away with the following conclusions.
Without leverage a portfolio of 50/30/20 seems to make the most sense.
The Nomadic Samuel Portfolio 40/40/20 won this round of the games delivering great returns while also scoring highly in the Sharpe ratio and Sortino ratio categories.
But it didn’t get the same returns as the more aggressive 80/20 or 100% equity only portfolios until it went to 50/30/20 and/or 60/20/20.
Thus, optimizing equities (small cap value over total stock market) and creating space for bonds and alternatives seemed to be best at this level.
At the 200X canvas level a more balanced approach of 1 part stocks to 1.5 parts bonds and significant exposure to alternatives produced the winning results.
Something along the lines of 30/45/25 stocks/bonds/alternatives.
When aggressive leverage was used (300 to 400% canvas) titling even more conservative with regards to equity exposure made the most sense.
A 25/55/20 or 25/50/25 portfolio was able to manage returns/risk better than any other configuration.
9) Gold Was The “Secret Sauce” Of Winning Portfolios
Gold was the “secret sauce” for all of the winning portfolios including the Ray Dalio All Weather, Risk Parity Portfolio and Harry Browne Permanent Portfolio.
Without allocation to an alternative sleeve guaranteed portfolios a best case scenario of -3 years sequence of returns risk.
Simply adding some gold allowed four portfolios to only have a negative 1 year sequence of returns worst case scenario.
The key point being that gold is uncorrelated to both stocks and bonds.
It’s volatile itself though, so held on its own, it’s a risky investment.
But when combined in the right combination with stocks and bonds it proved to be the “missing ingredient” for stock/bond only mandates.
10) There Are Better “Alternatives” Than Gold
Last but not least as great as the Risk Parity Portfolio, Ray Dalio All-Weather Portfolio and Harry Browne Portfolio did in this battle of the leveraged portfolios competition they can all be substantially improved.
Considering that “gold” is a volatile alternative asset class investors ought to consider uncorrelated asset classes/strategies that are better at managing risk in addition to (or as a replacement) to long gold-only mandates.
Managed futures strategies offer just that with adaptable long/short positions in global equity, bond, currency, metals and commodity indices.
Furthermore, long volatility strategies offer “portfolio insurance” for blackswan types of events.
Certain model portfolios taking advantage of managed futures and options strategies are available to investors today.
One should carefully consider the Cockroach Portfolio, Dragon Portfolio, Return Stacked 60/40 Portfolio and Picture Perfect Portfolio (my creation) as a modern take on the Risk Parity Portfolio, Ray Dalio All-Weather and Harry Browne Permanent Portfolio.
For instance, I’ve written about 10 ways an investor could improve upon the Ray Dalio All-Weather Portfolio.
There are ways to optimize your alternative sleeve moving beyond just gold in a way to build more robust, regime ready and efficient portfolios.
One of the primary goals of this site is to explore all of these alternatives.
But for those looking for a list of potential alternative strategies should consider the following.
- Private Equity
- Trend-Following (Managed Futures)
- Managed Futures Other Strategies (Carry, Value, Seasonality, Arbitrage, etc)
- Long Volatility Strategies (Put and Covered Calls)
- Gold
- Cryptocurrency
- Active Extension Equities 130/30
- Long-Shot Equities Net 60
- Market Neutral Equities
- Merger Arbitrage
- NFTs
- Art, Wine, Collectibles
- REITs
- Real Assets
- Private Debt
- Factor Optimized Equities (Min Vol, Value, Momentum, Quality, Size, Yield)
- Reinsurance
Nomadic Samuel Final Thoughts
The battle of the leveraged portfolios opened my eyes to the potential use of leverage as a portfolio enhancer and/or destroyer.
Leverage used in concentrated applications (single asset class strategy) often leads to disaster as you dial up potential risk.
Leverage utilized thoughtfully in an equal parts stocks-bonds-alternatives approach can enhance returns while controlling for volatility and risk.
It’s all a matter of how you use “leverage” at the end of the day.
Personally, I would be very comfortable with a 200% level canvas portfolio of uncorrelated multi-strategy equity, bond and alternative sleeve that is perfectly balanced.
I’m confident I’d achieve higher returns than a 100% equity only mandate with a level of smoothness that puts that type of single-asset class portfolio to shame.
But that’s just me.
Now over to you.
What do you think?
Wow! cool