Sweet Leverage!
How Little It Takes to Make a Giant Difference
Using 3 ETFs From the Worldwide Portfolio
Percent Gains--Weekly--Hypothetical
5.8 years June 21, 2002--March 21, 2008
See Comments below
I was astonished when I found how little leverage it takes to expand performance results so powerfully. More on this below. I was astounded when I found how little leverage it takes for portfolio ruination. It's the sweet and bitter. It's Goldilocks and the Little Girl Who Had a Little Curl. It's conventional weapons and WMD. Whew! What danger and opportunity ...
To create this 'system', I took three of the top-performing ETFs in the Worldwide ETFs Portfolio and stayed continuously invested in the best performing (top ranked) fund each week. No timing was involved.
Next I added a timing factor based on the trend direction of the portfolio. This commanded the system portfolio to be in and out of the market periodically. See the brown up/down indicator and the corresponding flat portions of the red curves in the chart above.
The funds used are iShares Brazil (EWZ), iShares Pacific ex-Japan (EPP), and HOLDRS Oil Service Industries (OIH).
Both the red curves include timing. The difference between them is that one uses leverage (the Brits call it "gearing"), and the other does not. The top red curve, for example, includes leverage here of 0.30 (borrowing an additional 30% more to add to your initial cash investment) to create a portfolio value of 130% (1.3 times) of the initial cash amount invested. This is low leverage. We will see in more detail below what it does to results. You can see in the chart above it almost doubles the system total gain from 679% to 1236% over the period shown.
Brokerage firms lend 'margin' (100%) to accounts to make purchases. Total initial market value of the assets purchased is 200%. That's leverage of 2.0 times cash. You can see in the table below what that does to profits and drawdowns.
Bear Stearns is reported to have had balance-sheet leverage of 34 to 1--which took it under. It could not raise enough cash in enough markets to pay back on demand enough of the debt it had borrowed. The markets had disappeared. Goldman Sachs has alledged leverage of 28 to 1. Merrill Lynch has 33 to 1. LTCM had 100 to 1 ... devastation! And so on.
The first lesson here is to leverage only highly marketable, highly liquid securities. The second lesson is the table below. The first column is the amount of leverage. The second column is the compound annual return the portfolio produces. The third column shows the compounded profit over 5.8 years. Next column, the worst weekly drawdown over 300 weeks, and finally, the longest drawdown in weeks over the same period.
For example, with leverage of 1.3, portfolio profit is 57% per year which compounds to a gain of 1236%. The worst-case drawdown is -25.7% and the longest drawdown period is 19 weeks.
Peak leverage gains occur at 5.0 times the initial principal invested. Profits explode to 193% per year and +47,536% over 5+ years. But who can stand a drawdown of -78%?
The way to use this table is to pick the worst-case drawdown you think you can tolerate (column 4) and settle for that level of leverage.
TABLE OF RESULTS
Relation of Leverage to Profits & Drawdowns
|
profit |
compd |
drawdn |
longest |
|
levg |
%/yr |
tot%prof |
% |
dd wks |
|
1 |
43 |
679 |
-20.1 |
19 |
|
1.1 |
48 |
836 |
-22.0 |
19 |
|
1.2 |
52 |
1021 |
-23.9 |
19 |
|
1.3 |
57 |
1236 |
-25.7 |
19 |
|
1.4 |
62 |
1487 |
-27.6 |
19 |
|
1.5 |
67 |
1777 |
-29.4 |
19 |
|
1.6 |
72 |
2112 |
-31.2 |
19 |
|
2.0 |
91 |
3999 |
-38.1 |
19 |
|
3.0 |
138 |
14335 |
-53.9 |
19 |
|
4.0 |
175 |
33100 |
-67.2 |
19 |
|
5.0 |
193 |
47536 |
-78.0 |
19 |
|
6.0 |
184 |
39217 |
-86.5 |
19 |
|
7.0 |
143 |
15977 |
-92.6 |
19 |
|
8.0 |
74 |
2258 |
-96.8 |
19 |
|
8.9 |
-5 |
-26 |
-99.1 |
19 |
This table of profits and drawdowns is based on simple arithmetic. It depends on time and volatility. The longer the time and the higher the volatility, the bigger the drawdown. It can be calculated for any portfolio of assets with a known rate of return. It will tell you with precision at what level you will be ruined. (More on leverage, with graphic examples, see here.)
Methods to reduce risks. Wait for a drawdown. See Tips for Getting Started. Or, note in the table that the longest drawdown is 19 weeks. If you divide the total amount of money you wish to commit into, say, four parts, you will never be caught paying top dollar at the start of a drawdown. Commit the first part right away, then the remaining parts every six weeks until fully invested. Or, depending on the size of your assets, commit to some other graduated entry schedule to reduce your average cost price and therefore your risk.
Convenience. Modern financial technology allows us to sell short without selling short and to leverage without leveraging (borrowing to increase our gains)--all with the blessing of the SEC and the Department of Labor (double surprise). Families of funds like Rydex and Proshares and others offer shares already leveraged to 200%. So, no matter how much or how little cash you put in, your market results will be 2 times what the market does. You look up in the table what 2 times leverage will do to you. 91% per year is attractive, and 4000% in five and three-quarter years is a sweet joy. But a 38% potential drawdown is more than you want to tolerate. To get the 2.0 back down to 1.3, simply divide 1.3 by 2 which gives you 0.65. Take the total amount of money you want to commit to the trade and multiply that amount by 0.65. The result is the amount of dollars you will use to invest in the 2x leveraged shares offered by the funds company. Valid for IRAs, etc. You can do the same thing with leveraged 'inverse' shares. Also valid for IRAs, etc.
Caveats.Drawdowns can be worse than those during the 5+ years shown in the table. Decimal-point precision in depicting experimental financial phehomena is generally always misleading. It gives an impression of exactitude which does not in fact exist. And, as always, Monday morning's prices, as well as next month's, or next year's, or next decade's remain perpetually a coin toss--the probability is 50%. Nevertheless the impression the data give--or the charts depicting the data--is a useful psychological tool to help assess the potential utility of system for a trader or investor.
The old English nursery rhyme goes, There was a little girl who had a little curl right in the middle of her forehead, and when she was good she was very, very good, and when she was bad she was horrid. Today she's horrid, and Goldilocks is out the window and into the forest when she hears the bears approaching.
If Messrs Bear and Stearns and Meriwether and colleagues and Merrill and Lynch and Goldman and Sachs and a host of other very bright and lucky (now unlucky) professionals around the world had consulted a little table like the one above, the financial history of the world and the Nation would be radically different today as this is written.
In the pre-dawn dark of July 16, 1945 in the Jornada del Muerto desert of Alamogordo, New Mexico, USA, the first weapon of mass destruction in the era of human history was detonated. Original sin was reborn: the power to annihilate--a leap of intelligence, without the good will to control it. ""We were reaching into the unknown and we did not know what might come of it," the Commanding General said.
The highly contagious global credit explosion now and its aftermath are today's equivalent of WMD in the electronic kingdom of modern finance.
Hubris is the terminal disease of ignorant success.
Comments
4/7/2008 12:30 p.m. EDT
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