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Today’s blog is an important one for several reasons so if you’re not accustomed to reading my blogs  (no offense taken)  please consider giving it a look today  🙂

I get so many great questions from the community and please keep it up, but if there’s one that comes up more often than any other I would say it’s today’s blog topic:

 “Can we replace MDY, IEF, GLD with leveraged products?”

Ok, let’s address this topic of leverage.  So last week I showed the performance of all the individual components of the VTS Tactical Balanced Strategy which you can view here.  Roughly speaking we tactically rotate between:

MDY Stocks  ~  54% of the time
IEF Bonds  ~  23% of the time
GLD Gold  ~  23% of the time

 

Before we get into the micro details of backtested performance using leverage I always like to take a few steps back and just address the macro points first.

 

1)  I almost never support the use of leverage.  Now there are certain market environments when I will make exceptions but for the most part I see no reason to use leverage.  I always say if a strategy requires leverage to perform well it’s not worth trading.  The success or failure of anything shouldn’t depend on taking on excessive risk so that’s strike one.

 

2)  Roughly 85-90% of active fund managers underperform the S&P 500 in the long-run.  Since the VTS Tactical Balanced Strategy already handily beats the S&P 500 by reducing drawdowns, I see no reason to entertain leverage.  It’s already doing it’s job quite well without it, so that’s strike two.

 

3)  The Balanced Strategy is designed to be a “core” portfolio position which means it’s meant to be the largest allocation of investment capital.  It’s always in my best interest to manage the bulk of my portfolio as safely as possible and to keep the drawdowns  (especially during recessions)  to a minimum.  That means I can take on some additional risk with smaller portions of my portfolio to invest in volatility and options and I can do that confidently because I have the core holdings taken care of so that’s strike three.

 

Basically, it’s a no to adding leverage.  However I can only ever share what I do and how I invest.  I can’t tell anybody else what to do with their money so I will certainly go through the exercise of showing you what other leveraged options are out there and everybody can make their own decisions that match up to their own level of risk tolerance.

 

1)  We are in GLD Gold about 23% of the time.

The leveraged choices:  GDX which is the gold miners stock ETF and UGLD which is a 3x leveraged gold ETF.

Even if the results of substituting for GDX or UGLD were good I still wouldn’t ever consider using them.  Our gold allocations are the safety positions.  We simply can’t afford to be taking additional risk with this portion of the strategy.  And thankfully the results are actually worse on a risk adjusted basis because of those nasty drawdowns so it’s not worth it.

The verdict:  It’s a hard no on substituting GLD.

 

2)  We are in IEF Bonds about 23% of the time

The leveraged choices:  TLT which is 20+ year US Treasury’s and TMF which is a leveraged 3x 20+ year US Treasury ETF.  Now TLT isn’t technically a leveraged product but because the duration is longer the yield is also higher which increases the potential profit.

Again our bond portion of the strategy is meant to be a safety position so I see no reason at all to be taking on that extra risk.

* Also remember bonds have an inverse relationship with interest rates. 

As rates go up, bond funds underperform and the Fed has already signaled several more rate hikes going forward which will put pressure on bonds.  At this point in the market cycle there’s no reason to be using leverage here, and in fact the only substitution that makes sense right now is possibly cash.

The verdict:  TMF is out for sure in any and all market conditions as the risk of drawdowns is too great for such limited reward.  TLT is a reasonably good choice if we were in a stable interest rate environment or even better, one where interest rates are decreasing.  If we return to that kind of environment in the future I could entertain the possibility of using TLT but now is not the time.  I for one will be sticking to IEF until the Fed starts signaling an end to rate hikes.

 

3)  We are in MDY Stocks about 54% of the time

The leveraged choices:  I know there’s plenty of 3x leveraged products but come on, I hate leverage so let’s not get carried away.  The only option here is SSO which is a 2x S&P 500 product.  There’s the 2x S&P mid-cap MVV as well but it’s volume is lower so SSO is the one.

As you can see, the first 4-5 years following the financial crisis were years where one could make the case for using leverage.  It’s normal to see strong upward movement in the stock market following such a deep recession.  However in the last 3 years the results have been less impressive and that’s because this bull market is getting a little long in the teeth.  I’m not saying it’s over, perhaps it will last several more years.  However we’re already 9+ years in and interest rates are rising.  Again now is not the time to be entertaining leverage in stocks.

Here’s a quick litmus test.  We moved into MDY Stocks yesterday.  Would you be comfortable buying the 2x SSO instead?  If you are, I guess more power to you but I know for myself I’m not even feeling great about 1x MDY let alone leverage.

The verdict:  In the few years following a recession I think adding leverage makes sense.  Especially since my signal recognition for the stock portion of the strategy has been very good.  The increased drawdowns for adding leverage are still quite manageable so that’s an option for a few years down the road.  Right now, again I for one will stick to MDY.

 

In a perfect world:

If and when we return to a market environment where I am expecting strong growth in the stock market and the Fed is signaling a stable or decreasing interest rate policy, at that time I may consider trading 2x SSO Stocks, TLT Bonds, and GLD Gold.

Unless something radically changes in the global economic situation, I would imagine this would only be after the next recession.  And that’s fine by me, I’m a very patient investor and have learned from mistakes in the past to not chase shiny things.

 

However I strongly believe now is the time to be reducing risk wherever possible, not taking on more.  The true secret to long-term investing success is risk management and minimizing drawdowns.

Everybody needs a stable “core” portfolio position and I invite you to consider the potential benefits of the VTS Tactical Balanced Strategy.  If you want to take on additional risk at this late stage of a bull market, I would recommend people do it with smaller portions of their investment capital staying mindful of how quickly things could go off the rails here.

I’m not trying to scare anyone, that’s not helpful.  At the same time though, let’s not forget the lessons of the dot.com crash and the recent financial crisis.  Avoiding the worst parts of those kinds of events will allow us to be very successful going forward.

 

Current VTS Total Portfolio Solution Allocations

10% VTS Conservative Vol Strategy  –  Optional replacement for lower risk tolerance investors

10% VTS Aggressive Vol Strategy  –  Optional replacement for higher risk tolerance investors

50% VTS Tactical Balanced Strategy

20% VTS Iron Condor Strategy

10% VTS Discretionary Strategy

Temporarily paused:  VTS Tactical Volatility Strategy

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