“you do not eat risk-adjusted returns”
How many times I have heard it. Well, not literally like this because, if you are able to frame it this way, you know it is not 100% true. Usually, it comes in the form of “stocks generate higher returns than that”. Meaning, why should I bother with a less volatile, higher Sharpe portfolio if, at the end of the day, I will earn less than allocating 100% to stocks?
For one, because of ergodicity. Even if you are comfortable with stock drawdowns and volatility and think your horizon is very long, you might need funds earlier than planned. While stocks are in said drawdown (if you are thinking that you have another “bucket” for that…well, then you are not 100% invested in stocks, meaning you are not earning the returns you think of). Or you might start investing at the wrong moment, in the sense that the returns going forward might differ from the recent and historical past.
It is returns AND the sequence of returns. It is the difference between arithmetic (what you think you are getting) and geometric returns (what you really get).
Thanks to Corey Hoffstein I recently discovered this blog; well, so far I just listened to the author in this podcast episode, to say the truth. But I hope to be able to do a deep dive soon about it.
Anyway, his latest post is an absolute gem about this topic.
“a higher Sharpe ratio portfolio is safer at any given common level of volatility compared to a lower Sharpe portfolio. And the easiest and surest way of increasing your Sharpe ratio is by increasing diversification.”
More importantly, Markku shows us that we can eat the Sharpe ratio. We just need to lever up the higher Sharpe portfolio to a higher volatility level.
In his example, if we bring the 60/40 up to the same volatility level of 100% stocks, we get higher returns. Conversely, we can get the same returns as a stock investor but with less volatility.
“The portfolio with the highest realized Sharpe ratio is guaranteed to have the highest mean growth rate among portfolios with equal volatility.” “In short, it is about maximizing the Sharpe ratio and leveraging to the desired level of risk.“
The cost of leverage obviously matters. As long as the cost-spread ABOVE the risk-free rate is less than the ratio between the levered overperformance vs the % of leverage, leverage adds value: any investor is better off investing in a levered high Sharpe ratio portfolio than allocating more to the high return/high volatility asset.
For example, in the case of the levered 60/40, Markku calculates that the cost-spread threshold is 1.33% (0.8 overperformance divided by 0.6 leverage). If you are familiar with IBKR margin spreads, the first tier (+1.5%) is not convenient but starting from the second one (+1.0%), even an IBKR margin loan makes sense.
Why am I mentioning this? Because the typical follow-up I receive for this reasoning is “Great, but how do I get leverage?” The good news for retail investors is that there are ETFs that offer leverage at a very low cost, very close to the risk-free rate. But even without them, if you are a “Europoor” like Twitter character Finumus loves to call European investors who cannot access US-listed instruments, you can do it with a simple (not optimal) Lombard loan from your broker (provided your portfolio is big enough).
Golden Butterfly
Even the thought of writing again about the 60/40 bores me to death, so today we will focus on the Golden Butterfly portfolio. This offers me as well the opportunity to discuss what some prominent (sigh) Italian YTers missed about the strategy (and its Weird Portfolio cousin) without alienating the good souls who have no clue what I am referring to (blessed you).
If the reason why you do not employ a Golden Butterfly (-esque) type of strategy is that it generates fewer returns than a 100% stock portfolio, may I introduce you to the Golden Butterfly levered up to the same volatility level:
Who’s winning the return race now?
As Markku said, if you want more profits you do not have to shift the portfolio allocation to the more volatile asset, you can simply add (or remove, if you want lower vol) leverage to the higher Sharpe mix available.
If your rebuttal at this point is about the fact that the Golden Butterfly (or any other portfolio) produces those results because of past correlations that might not replicate in the future, I invite you to listen to Meb Faber interviewing Jason Buck and Eric Crittenden. No one can be sure about that; but if you accept that the future can be uncertain, isn’t more diversification better than less?
Sure, in the case of the GB, maybe Small Cap Value might not offer the same overperformance it did in the past (actually, it did not provide it for the last 15 years and the portfolio is still ahead…), but the GB is just a variant of the Permanent Portfolio with a higher tilt to stocks. How wrong things can go while still living in a good environment for stocks?
The second rebuttal is that GB overperformance can be linked to specific instances in the past, like the 2008 crisis. No shit mate! This is a feature, not a bug. If the portfolio, any portfolio available to anyone, would always outperform then everyone would have already invested in it (ok, not everyone. The dividend stans would still prefer to earn less). I would agree with this point if looking at 50 years of data (not the 20 everyone is checking) there would be only a single instance in which there was a positive divergence: sure, data mining. But if we are dealing with strategies that can underperform for 10 years and still be valid, and we are, the fact that we can pinpoint a few moments over 20 years where a DEFENSIVE strategy worked, ain’t that the whole point of the game?
This is hedge fund material without the associated 2 and 20 fees: track when things are good and protect when things are bad.
Levered Bonds
So, how do we get leverage at a reasonable cost? And would this leverage provide the same results that we just obtained?
Unfortunately, (good) leveraged ETFs are relatively new to the market. So for the lads that do not believe the previous backtest, I have limited options. But… look what happens if I use UBT, the 2X Long Treasury ETF from ProShares:
ProShares products are bad because they reset the leverage every day AND their cost is massive (0.95% for this beauty). And yet we get there!
If you are wondering where is $SHV 2x…good spot, I guess? $SHV is nothing but long cash, so we can net it out with the short cash position due to leverage. In the first example I left it there to make the step unlevered -> levered clearer but netting those positions out doesn’t change the end result (when trading costs are set at 0).
Full Levered Portfolio
Thanks to our friends at Wisdom Tree we can now create our levered GB with just 3 ETFs (plus one to just reach the right vol point):
For $1 invested in $GDE you get $0.9 of $SPY and $0.9 of $GLD (ok, it is not exactly $SPY because they do not want to pay S&P the fee but it is $SPY at the end of the day).
Here is the performance compared to the two previously described portfolios:
There is even a little room to lever the portfolio more and get higher returns! 😉
Or you can lever it down to get the same $SPY returns with less volatility. Any excuses left?
Oh yes, you live in Europe (ex-Switzerland) and you do not have access to $GDE. You do not have the instruments or you do not want them? Because $GDE is brought to you by the same guys behind $NTSX and last time I checked, you did not buy $NTSX even if you could. The UCITS version of $NTSX has 8m of AUM, if you do not have the instruments at this point is just your fault, I am sorry 🙂
Anyway, this wanted to be a simple example, so the next time someone tells you that you cannot eat the Sharpe ratio, you can throw this model in their teeth and check who can eat then.
BONUS POINTS
Another thing that makes me go like
is when lads complain “those lazy portfolios are made for US-based investors, if you need EURs the picture is different”.
Let’s go and check this with our beloved PortfolioCharts tool. You can see how a particular portfolio/allocation would perform in a different country by simply changing the “Home Country” field in the top-right box of the “My Portfolio” section. Since PC added the Membership tier, if you are not a member you can make these changes in the Charts section, one chart at a time.
The quality of the below images tells you why I chose a career in finance. Anyway, on the LHS you have the classic, US-based, Golden Butterfly while on the RHS you have the “Italian version”
In this instance, there are mainly two things that affect all the changes:
- EUR/USD exchange rate
- Italian inflation instead of the US one
The results are intuitive…up to a point. The Italian-GB has a higher average REAL return but the distribution has fatter tails (as expected, since we are adding the FX volatility) and positive skew (not expected).
Do we lose the very core pillars of the OG Golden Butterfly? Yes. Does it really matter? Up to a certain point.
The higher volatility brings the SWR of the Italian-GB down to 5.2% (compared to 6.1%) and the PWR from 4.6% to 4.0%.
This is not great, until you realise that the 100% stock portfolio has a SWR of 4.1% and a PWR of 3.1% for a US investor and 3.5% (SWR) / 2.7% (PWR) for an Italian one. The Golden Butterfly is still miles ahead even for an investor that has to suck up all the FX volatility, if their goal is to have a smoother ride and, possibly, extract more juice from their portfolio during the retirement phase.
World exposure instead of US-only
That said, no one in Europe has a 100% USD-only portfolio. To make our experiment more credible, let’s use a portfolio like this:
The 50/50 split should represent a World Index-like risk exposure. (What it does not do is invest ONLY in Italian Bonds, because that’s stupid)
We do not get 100% there but we are close enough, innit? Meaning, even if you live in Europe and you spend EUR, this very simple (took more to do the print screens than to think about the allocations) World Golden Butterfly would do it for you.
What I am reading now:
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12 Comments
Cif · May 17, 2024 at 10:54 am
Great post as always! I don’t fully agree on the low NTSX AUM blame being put on the investors alone – there are differences between UCITS version and the rest (UCITS is ESG-only, there are no NTSI/E to implement a diversified portfolio, and people in the Eurozone might not want to have all their bond allocation to unhedged US treasuries), but it’s a shame nonetheless. Would you consider manually rolling Eurozone bond futures a valid alternative? Even if not that tax efficient overall.
I do have a question: do you think levering up the more volatile assets of the portfolio via futures/LETFs would hurt the overall returns (cause of the higher volatily drag) vs levering up the less volatile assets? Or does it not have a significant impact, everything else considered?
Also, since you mention factors – I’d love to read your take on factor investing in one of your future posts. Since you mention LowVol a lot I take you’ve read Betting Against Beta 🙂
TheItalianLeatherSofa · May 18, 2024 at 12:27 pm
well, I suspect anyone has a part of their portfolio exposed to US stocks. NTSX gives you that and a bit more (including some tracking error) 😉 I get your point, I just wanted to be cheeky (forget that the alpha comes from levered Treasuries, the relevant part is that it works).
I never bought/sold a future in my life, so I cannot really comment on the practicalities of the strategy (including how to manage the margin). But in theory that achieve the same goal, yes. TBH I do not know the underlying of the futures, it has to be a real “fly to quality” asset to mimic Treasuries.
I think it is more important how frequently you rebalance the portfolio to reduce the vol drag than the asset that is levered. But if you can do it on the less volatile asset, you probably save yourself some work. Play a bit on PortfolioVisualizer to see the different effects.
Factors are a bit of a mess: I use them more as an inverse hedge (things might work really well and if they do not, I do not risk much…if you diversify between factors and issuers) but the more I read, the more I find implementation issues.
raffaele · May 20, 2024 at 8:08 am
tutti gli etf (leva 2) e tutti gli etc (leva 3) azzerano la leva ogni giorno quindi hanno bisogno di una direzionalità chiara e in quel caso sovraperfomano sia in salita che in discesa.io da tempo utilizzo una strategia ma come strumento ho optato per i futures che sono meno efficienti fiscalmente ( paghi le tasse almeno 2 volte all’anno) ma non ti esponi al dollaro (solo il margine che blocchi) e in fase laterali non soffri dell’effetto compounding
Enrico · May 17, 2024 at 2:07 pm
Hi Nicola, since I started reading your work, I decided to invest in NTSX. It’s a pity that other pieces of puzzle are still missing to build the portfolio I want, but among thousand defects we have here there is a value: the art of getting by..
TheItalianLeatherSofa · May 18, 2024 at 12:09 pm
That missed call starting with +39 must have been the CONSOB then :D:D
I 100% agree with the art of getting by
Alex · May 18, 2024 at 9:35 am
You mentioned $NTSX as an (the only easy?) option for us “Europoors”. I’ve been looking at NTSX for about a month and I noticed that while the AUM moved around between 8-9 mil, the number of underlying shares has not moved at all, indicating that the AUM has only been influenced by the changes in NAV. I am not too familiar with the practices of ETF creation or redemption, so there might be a misunderstanding here. But as the size of an ETF should be a pretty good predictor for its long term survival, I am wondering if WisdomTree only updates the number of outstanding shares and NAV irregularly or if there really haven’t been any inflows over the last month (which would not be a good sign for the its chances of survival)? Do you have an opinion or educated guess on the future of ETFs like NTSX in Europe – is it too much of a niche for there to be a relevant amount of demand?
TheItalianLeatherSofa · May 18, 2024 at 12:34 pm
there are 2 competing forces related to NTSX, from my very limited POV:
– volumes are made by financial advisors. If WT is not able to drag in some of them (and in Europe is harder than in the US because independent advisors are are few and far between) the AUM of the fund will never grow.
– WT has already the platform to issue ETF in Europe and they run the same strategy in the US: the costs of keeping NTSX listed should be relatively low for them.
I would bet they give themselves 3 years: if in 3 years the AUM is not above 50m they will kill it
Alex · May 26, 2024 at 5:32 pm
Thank you for your insightful answer. At least for Germany I can add the anecdotal evidence that WisdomTree ETFs tend to not be available as free saving plans with most brokers but need to be traded actively, further limiting the possible attractiveness for a lot of private investors saving for retirement.
Still, the fund seems to be growing – the number of outstanding shares has finally been updated and increased by around 11% in comparison to April. That would amount to monthly inflows of around 1 million € right now. I will keep an eye on the growth of the ETF – and in the meanwhile carefully replacing the MSCI World part of my monthly investments by NTSX.
TheItalianLeatherSofa · May 27, 2024 at 8:57 am
happy to help!
Unf in a lot of instances, the “pay to play” scheme applies. Meaning WT has to pay instead of the customer to be added to those lists
Marco · May 21, 2024 at 12:59 pm
After reading the post, I spent a day in real euphoria, constantly imagining new 90/60 leveraged ETFs on the market that could replicate the indices we all invest in but with better Sharpe ratios. Then a doubt started to creep in: what if the market plummeted by 50% and the managers received a margin call? What would happen to the ETF? Is there a risk of losing the entire invested capital?
TheItalianLeatherSofa · May 22, 2024 at 11:24 am
That risk is not 0.
But there are a lot of mitigants in place. For example, if in a tail scenario bonds and stocks are inversely correlated, you care less that one side is losing 50% because the other side is going up (assuming you got a loan to buy bonds, if the value of those bonds goes up, the lender is less concern about the quality of the collateral). The shock has to happen in a very short period of time, otherwise rebalancing between the two buckets reduces the catastrophic risk (the value of the etf still goes down).
the issue with levered ETFs is that they cannot call you, the investor, if they have a margin call; they have to manage it with the assets in the wrapper. But as long as the assets are liquid and the leverage is reasonable, the atomic risk is very low.
Now I understand that there are many out there that read “low risk” and think “OMG this is trash”…from here it is up to you 😉
Universa Investments’s case against NTSX (sort of) - · June 8, 2024 at 7:35 am
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