Adding Alpha With Leveraged ETFs

NEW YORK (Scott's Investments) -- I had a thought tonight while mowing lawn - can individual investors add portfolio alpha by allocating a small percentage of their portfolio allocation to a strategy which rotates into leveraged ETFs? In other words, can we decrease portfolio volatility and increase portfolio returns by rotating a small percentage of our portfolio in and out of leveraged ETFs? I performed a similar test earlier this year but it involved a 50% allocation to leveraged ETFs, which is way too high for most risk-adverse investors. The full results and methodology of that test are available.

First, some important caveats. The results below are over a very limited time period, primarily due to the relatively short trading history of leveraged ETFs. Thus, be careful not to project historical returns into the future. This is an important point that is too often overlooked.

Second, leveraged ETFs carry additional risk. They are intended as short-term trading vehicles and I would recommend reading the prospectus for the two ETFs discussed below (SDS and SSO) at Proshares website. Compounding -- the likelihood of the funds' returns over periods longer than one day to differ from the target returns -- is a critical concept to understand before investing in leveraged ETFs. Finally, commissions and taxes are not included in the results and will impact returns.

Related: Time to Buy Gold or Stocks?

Now, on to the fun stuff. The results of these backtests are courtesy of ETFReplay.com (check it out). I started with a basic buy-and-hold portfolio of five ETFs that might represent a typical investor portfolio. The portfolio consists of the following ETFs and I included the month/year trade data was available on each ETF:

• iShares Barclays Aggregate Bond (AGG) (Sept. 2003)
• PowerShares DB Commodity Index (DBC) (Feb 2006)
• iShares MSCI EAFE Index (EFA) (Aug 2001)
• iShares MSCI U.S. REIT (VNQ) (Oct 2004)
• Vanguard MSCI Total U.S. Stock Market (VTI) (May 2001)

If an investor had bought and held this portfolio in equal weight, the returns since 2006 are below. Note that for the beginning of 2006 DBC was not held and the portfolio was re-balanced February 15, 2006 to include DBC in the returns:

Total Return: 29.1% vs 4.6% for SPY

Volatility: 20.7% vs 24.4% for SPY

Compound Annual Growth Return: 4.6% vs .8% for SPY

Sharpe Ratio: .13

Correlation to SPY: .92

Strategy drawdown: -45% vs. -50.9% for SPY

Bottom line: A diverse buy-and-hold portfolio still suffered significant portfolio drawdowns in 2008. It has taken two to three years to gain back what was lost in 2008. The portfolio still outperformed SPY (SPY) on returns and volatility, but remained highly correlated to SPY and I suspect that the individual investor may not be satisfied with an equity curve resembling a thrilling roller coaster.

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