How To Beat the Market Using Leverage and Index Investing
Financially reviewed by Patrick Flood, CFA.
Most investors — even professionals — fail to beat the market. Can it be done? Perhaps. Here we’ll explore how to beat the market using leverage and index investing.
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Can You Beat the Market?
Yes and no. Technically, yes of course it’s possible. Perhaps the most famous example is Warren Buffett. But you’re not him. Moreover, for the most part, his investing style provided excess exposure to the Value and Quality factor premia historically, nearly fully explaining his above-market returns.
For most investors, the answer to the question above is an emphatic “no.” It is well known that the vast majority of investors — even professional fund managers — fail to beat the market, even in bear markets. If you’ve arrived on this page, you likely already know that fact. I won’t delve into the details and the data too much, but I’ll provide a brief overview to set the context for the discussion below on how to beat the market.
Institutional investing, which is responsible for the majority of invested assets, is largely a zero sum game, as skilled managers are competing with each other in a global market. Fund managers’ underperformance for their clients is then exacerbated by fees.
Arguably more importantly, there will always be an asymmetry of information that acts as one of the many disadvantages for retail investors compared to institutional investors. Hedge funds and pros on Wall Street spend a huge amount of time and resources to get information weeks, days, even minutes before that information is made public. Thus, there’s an argument to be made that any information available to the average retail investor like you or me has already been priced in to a stock’s share price in a reasonably-efficient market. The sooner you accept this unfortunate fact, the better your long-term returns will be.
Active management and stock picking also introduces additional uncompensated risk in the form of excess exposure to single companies, and decreases reliability of outcome. As John Bogle, considered the founder and father of index investing, said, buy the whole haystack instead of trying to find the needle. Even Buffett himself advises retail investors to buy a plain ol’ S&P 500 index fund with low fees, which is where he’s instructed most of his wife’s inheritance to go.
So why am I spending time discussing why it’s nearly impossible to beat the market in a post that’s supposed to be about how to beat the market? To set the stage for a tactic that is statistically the best way to assume additional, compensated risk: combining leverage with tried-and-true index investing.
What Is Leverage?
Leverage refers to increased investment exposure through borrowing, without additional capital outlays. In a nutshell, taking on leverage means taking on more risk — and more volatility — for the potential of greater reward. If you’ve bought a home with a mortgage loan, you’ve used leverage.
Excluding options and futures contracts (complex derivatives for advanced traders), investors can take on leverage via leveraged ETFs — ETF products that provide enhanced exposure — or through , a collateralized loan from your broker against your portfolio in a taxable brokerage account. An example of a leveraged ETF is the Ultra S&P500 (SSO) from ProShares, seeking to deliver 200% of the daily returns of the S&P 500 Index. An example of a margin loan is the relatively cheap margin from M1 Finance known as M1 Borrow.
An investment of $100 in SSO gets you $200 of exposure. If the S&P 500 goes up by 10%, SSO goes up by [roughly] 20%, so you’ve now achieved a $20 gain instead of just a $10 gain. Borrowing 35% against your invested balance (the max for M1) gets you $135 of exposure for your $100 investment. A 10% rise in value of the assets gets you a $13.50 gain in this example instead of a $10 gain. These examples obviously ignore the costs of borrowing.
I won’t delve into the specifics of leveraged ETFs here. I did that in a separate post. Just know that because they reset daily, they won’t behave quite the same as a margin loan. That said, with leveraged ETFs, you can only ever lose the capital you put in. With a margin loan, in some cases, depending on your leverage ratio and your broker’s maintenance requirement, you can lose more than you put in, potentially plunging you into debt if the market crashes and the amount you owe is greater than the value of your investments. At the very least, you’d trigger what’s called a margin call, where you either have to deposit cash to make up for the loss or sell your investments. Also note that margin is usually only available for taxable accounts and cannot be used in retirement accounts, whereas most brokers allow leveraged ETFs in retirement accounts.
Leveraged ETF naysayers cite volatility decay from their daily resetting (also known as beta slippage) as a reason to never hold them long-term. I’ve delved into this topic in previous posts but it bears repeating briefly here. If the underlying index moves up consistently with decent momentum, volatility decay actually works in your favor. This is why UPRO, the 3x leveraged S&P 500 ETF, has delivered close to 5x the returns of the index since its inception instead of the proposed 3x. In short, holding leveraged ETFs for more than a day is not the boogeyman it’s made out to be. If you’re curious to see the math, I would encourage you to check out this page.
It’s also actually been proposed that investors should not only diversify across assets but also across time, employing leverage early in one’s investing horizon to actually reduce risk near retirement by effectively spreading out your money more equally so that one single year affects the portfolio to a lesser degree than it otherwise would. I myself utilize long-term leverage in my own portfolio with funds like NTSX (1.5x 60/40), UPRO (3x S&P 500), and TMF (3x long-term treasury bonds). I even designed some leveraged versions of popular lazy portfolios like the All Weather Portfolio and the Permanent Portfolio. I reviewed some of the best leveraged ETFs here.
In short, while it’s definitely important to understand the fundamental nature and potential pitfalls of the use of leverage, it can be an extremely powerful tool and I have no problem holding a highly-liquid, broad index leveraged ETF over the long term. Remember though that with that increased exposure comes greater volatility and risk. If the S&P 500 falls 10%, a 2x leveraged fund will fall 20%. As such, leverage is likely only appropriate for experienced investors who have a high tolerance for risk.
Utilizing leverage is much more important and impactful for young investors with a small amount of capital, allowing them to increase exposure to stocks while young, and have a more consistent exposure on average across their investing horizon, which is the whole idea behind Lifecycle Investing.
How To Beat the Market Using Leverage
The stock market has historically returned about 8% per year on average. So does a 2x leveraged S&P 500 ETF return 16%? Unfortunately it doesn’t quite work out like that. Recall that leverage enhances losses too, dropping further than the market when the market drops, meaning it takes more momentum to come back up easily, e.g. a 33.4% drop in the market would wipe out a 3x leveraged position. Thankfully, the market tends to go up over the long term, and circuit breakers halt daily trading if significant crashes occur.
So how can we beat the market with leverage?
I would submit that a “modest” amount of leverage (100–135%) on a broad stock market index like the S&P 500 is a much more sensible assumption of risk than picking individual stocks, and should allow for market outperformance over the long term. At least it has historically. Here’s how a 1.35x leveraged S&P 500 portfolio would have worked out against the S&P 500 from 1985 through September, 2020:
Note, just like I described, the greater volatility and drawdowns, but also the significantly higher return, with a nearly identical risk-adjusted return as measured by Sharpe. Keep in mind that past performance does not guarantee future performance.
I personally wouldn’t go past about 2x with 100% stocks, as drawdowns start to become too great in my humble opinion, risk-adjusted returns start to diminish, and the portfolio may not recover for a long period of time. The paper I linked earlier found the optimal leverage for the S&P 500 to be about 2. Above that, you’ll likely want a hedge like bonds.
So what if we diversify across multiple asset classes? The traditional 60/40 Portfolio (60% stocks and 40% bonds) is said to be a perfect balance of risk and return. Bonds protect the downside, reducing portfolio volatility and risk, making this a popular portfolio for risk-averse investors and retirees.
While the 60/40 Portfolio is almost certainly suboptimal for a young investor with a long time horizon and high risk tolerance, levering up that same position can potentially enhance returns while potentially maintaining a sensible risk profile similar to that of the S&P 500. Below is a backtest of 1.5x constant leverage on a 60/40 portfolio (resulting in 90/60 exposure) using long-term treasury bonds vs. the S&P 500 Index and our previous 135% S&P 500 from 1985 through September, 2020:
Notice that now not only did we get a considerably higher return, but the 90/60 portfolio actually had lower volatility and smaller drawdowns, and thus a higher risk-adjusted return compared to the S&P 500. NTSX is a relatively new ETF from WisdomTree that delivers this exact exposure; I use it myself in my taxable brokerage account. Remember that because they’re using derivatives and swaps to borrow, these ETFs won’t behave quite the same as a simulated constant leverage.
Taking this example to the extreme, what if we apply 3x leverage to the traditional 60/40 Portfolio? At the time of writing, 3x is the highest leveraged ETF available for the S&P 500 to my knowledge. Below is how that would have worked out historically versus our previous example:
Recall what I said about the risk-adjusted return starting to diminish after a certain point. Here we have a much greater return obviously (talk about market outperformance!), but with much greater volatility and risk and a slightly lower risk-adjusted return than the 90/60 portfolio. Also note that I’m definitely not suggesting you should go put all your money on 3x 60/40, despite how enticing the image above looks. At the end of the day, it will come down to your personal time horizon and risk tolerance. This nominal exposure of 180/120 is actually very close to a now-famous portfolio proposed by a member of the Bogleheads forum called Hedgefundie. I wrote about this portfolio strategy in detail here if you’re interested.
With interest rates as low as they are, bonds may not provide the same downside protection that they have in the past. Enter other assets like gold. While gold may not be a reliable inflation hedge, it inarguably offers at least a short-term diversification benefit due to it being uncorrelated to both stocks and bonds.
The famous All Weather Portfolio from Ray Dalio utilizes stocks, bonds, commodities, and gold. It’s extremely popular because it minimizes portfolio volatility and risk and is designed to “weather” any economic environment. This extreme diversification usually sacrifices returns, but what if we apply some leverage? Levering up the All Weather Portfolio may provide somewhat of a “middle ground” for those wanting to employ leverage and take on risk but still be well diversified across multiple asset classes.
We can’t easily lever up commodities, and I’m not a big fan of them anyway; I wrote in detail about swapping them out for Utilities here. Making that switch and using 2x for gold and 3x for the other assets (there are no longer any 3x gold ETF products available), below is a backtest roughly illustrating how this leveraged All Weather Portfolio would have performed versus our previous 1.5x 60/40 (90/60) and 3x 60/40 (180/120) from 1987 through September, 2020:
Notice the greatest risk-adjusted return (Sharpe) for this leveraged All Weather Portfolio. It achieved a lower return than the 180/120 but had significantly lower volatility and smaller drawdowns. The 90/60 still carried the lowest volatility and risk of these three portfolios, but its comparatively lower return still resulted in it having a lower risk-adjusted return than the 3x AWP. If you’re using M1 Finance, you can grab this 3x AWP portfolio here.
Conclusion
Even with all the fundamental and technical analysis in the world, the market is nearly impossible to beat for average DIY retail investors picking stocks. Statistically, using leverage — borrowing to increase asset exposure — on a broad index provides the best chance for beating the market, and can be a useful tool for investors with a high tolerance for risk, especially those with a long time horizon and a small amount of capital.
While there are definitely important risks associated with the use of leverage, I maintain that applying a modest amount of leverage to a broad index or levering up a well-diversified portfolio is a far better, easier, and less time-consuming assumption of excess risk than stock picking.
In any leveraged portfolio, a strong stomach will likely be required during periods of market turmoil. Remember to regularly rebalance any leveraged portfolio if your allocations stray significantly from their intended targets. This is less of a concern with a brokerage like M1 Finance that automatically rebalances your portfolio using new deposits.
Also remember that using leverage — especially in the form of leveraged ETFs — increases portfolio risk and the potential for greater returns, but also the potential for greater losses. Do your own due diligence.
Which of the above strategies would you go with? Let me know in the comments.
Disclosures: I am long NTSX, UPRO, and TMF.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.
Originally published here at https://www.optimizedportfolio.com.
