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I'm a bad trader. There, I said it. I've got a diversified stock portfolio and my winners are outpaced by my losers. The truth is I don't have the time or the energy to do tons of research, and as much as I'd like to be an active trader, I really don't have the dedication to do so profitably. Fortunately, this realization has come somewhat early in my life and hasn't been too expensive. I'm ready to contentedly invest, with a Buy and Hold strategy, in the S&P 500 almost exclusively. But I'm wondering if I could make more...Enter ES.
My initial thoughts were that if the ES returns about 7% annually, and I keep a margin of 20% of the contract value, my annual return on investment would be 35%, but that can't possibly be right. Is there some form of leverage decay happening here than I don't fully understand? And, assuming I can stomach large swings, is there any long-term benefit to investing that 20% in ES contracts over something like SPY? My thought is that if the S&P goes up 7% on average, I must be poised to make more money if I'm leveraged, no?
Can you help answer these questions from other members on NexusFi?
Based on data going back only until 1950, the SP500 has returned an average return of 8% and an average Drawdown of -20%. This has occurred with a frequency of 75% up years and 25% being down years. The key here is that the max drawdown has been in excess of -50% a few times randomly across the decades.
The max leverage for the portfolio estimated would be:
- 2 if the max drawdown going forward would be 50% (1/0.5).
- 1.67 if the max drawdown was 60% (1/0.6 in the case of lehman crisis)
- 1.25 if the max drawdown was 80% (1/0.8 during the great depression)
Assuming ES@1950 and initial margins of 5500 would place it ~ 5.64% of the notional value. If one pushes the margin to equity up to 20% it is roughly using 4x leverage, a 25% drop in market value would wipe out all equity. The event of drawdowns increasing over time is an eventual certainty.
The converse however is counter intuitively true - the lower the leverage the faster it would take to climb out of drawdowns and a higher certainty of making money. Imagine making 10% in the 1st year and losing 10% in the 2nd year, you would need to make 11.1% in the 3rd year to breakeven. Assume the same payoffs but using it in a 3x levered vehicle, it would need 42.86% in the 3rd year to breakeven. In the event the 3rd year market returns 11.1%, the non levered fund would have broken even but the 3x levered vehicle would have only returned 33.33% and still be in a net deficit of 9.5%. This is known as the volatility drag but perhaps should be more apt as the "leverage drag".
Non Lever - +10% /-10% Yr3 requirement 11.11%
2x Fund - +20% /-20% Yr3 requirement 25.00%
3x Fund - +30% /-30%Yr3 requirement 42.86%
For a buy and hold strategy I would think nothing beats "traditional" stock picking.
This is exactly what I was looking for, and it's helped to clarify the concept a great deal. However, two things still come to mind:
1. While ES doesn't move at exactly +8% per year, there must be some performance and max draw down point in which the expected value of being 4x leveraged is more profitable than traditional investing. It doesn't strike me as something we could ascertain using a straight formula, but more likely something that could be analyzed with Monte Carlo simulations using varying draw-down and performance variables. My guess is that volatility drag has got to matter more when the long-term expectation of an investment approaches zero (or negative). With something that has proven to go up over the long run, wouldn't it stand to reason that leverage would be a better long-term play?
2. While we can certainly look at this from a leverage perspective, is that the right way to do it? If I put up $20,000 for one contract and there's a 25% draw down, I'd lose my investment, but I am in a position where I can put in another $20k (it would be foolish to put all my chips in play at once). Since the market has the fortunate habit of going up, doesn't the volatility drag become a moot point? I suppose it all boils down to this question:
In the year 2034, do you think the S&P will be above or below 2,000?
I offered to give you $20,000 today to buy and hold shares of SPY for that 20 year period, or 1 contract of ES for the same time frame, which would you choose?
1. Drawdowns vs StdDev - tturners footnote sums it up best and to also steal a quote "In order to finish first you have to first finish." Whilst stddev might only be 20% for equities, the max drawdown has been in excess of 60% which is the true measure which incapacitates any portfolio or fund. Monte carlo DD scrambling has placed these DD into a less than 5% chance of hitting them but yet it has been hit from decade to decade and it does little to reassure that it would not happen again. Drawdowns are a function of winning %, portfolio correlation and most importantly, increases with the square root of time. All these take into account a lot of assumptions which is rather unnecessary if no leverage is used and the max one can lose is 100%. If i recall correctly a study on buffett mentioned the max leverage used was 1.6.
2. Cash Drag - Some funds keep aside 5-10% cash which lowers their performance but gives them buying opportunities. Futures have the advantage of putting in a smaller portion of cash into margin and using the rest in money market equivalents known as notional funding. Setting 75% cash aside and using 25% to trade 4x leverage is akin to trading the portfolio as a whole would allow a 100% drawdown, however, trading total cash at 4x and holding it as a B&H strategy would only allow a 25% DD. If money is set aside to cover DD it would be the same as the first example.
3. I would consider looking at VOO Vanguard ETF with a lower expense ratio of 0.05% vs the SPY at 0.09%. You would spend $20 in commissions in futures ($5 roundtrip) for rolling 4x a year vs $50 in an ETF. However, to save the $30 would entail rolling the spreads efficiently and more importantly not forgetting to roll!
4. To achieve higher Compound returns would entail reducing stdev of the asset whilst average return remains constant.
Leveraging the asset would only entail larger drawdowns but if one can find a way to lower the stddev of the asset it would increase CAGR naturally and consequently leverage it up to a DD level of one's threshold preference.
This is outstanding. I think you've done as perfect a job as possible to tell me why this probably isn't the best idea. But I've got to poke and prod a little further because I'm an amateur and it's in my nature
If I recall, what you read about Buffett is that Berkshire Hathaway operates at 1.6 leverage, which he obtains through cheap insurance floats. My assumption is that that is an average, and some pieces operate at more and others at less. Beyond that, there are other factors at play for a company that large which would have no impact on me: Namely, I am a million times more liquid than Berkshire, and I don't have to be risk averse in the same way as a company which has to answer to its stockholders. Whether that translates into it being a good idea for me to use 4x leverage is still highly suspect. After our discussion, there is a good chance that if I go after this at all, I'll do it with like 2 or 2.5x leverage (and if I do that, maybe I should be investing in something like ProShares Ultra S&P, which is 2x leveraged).
To go along with your explanation of keeping cash on hand in low risk investments so that my contract purchase mirrors a direct investment, I will likely do that to a decent extent (especially in the early stages of the investment). The next part of this scenario is timing. I'd begin this pursuit only after some substantial pullback (10%+). What I think I know about the current market is that there is not much euphoria despite last year's great rally. People are on the lookout for bubbles, QE fears have been largely factored in, and the economy isn't booming. People are still hesitant. I don't see a 60% pullback looming (although, few people ever do) because the tell-tale signs just aren't there. Furthermore, by timing my entry to coincide with a draw down of some level that has already happened, I am limiting my risk. If the market continues to goes from 2,000 to 800, but I bought in at 1,600 I'm only impacted 50% rather than the full 60.
From a long-term perspective, perhaps a somewhat active trading approach would be ideal, even though I know it's usually folly to try and time the market. By using a trailing stop to make my max unleveraged draw down ~15%, along with perhaps some simple trend lines to signify increased chances of a reversal, and my risk could be further mitigated. I'd only be looking to actually act on the investment hopefully less than once/year, so while it isn't totally Buy-and-Hold, it's close. Given the nature of the the S&P, with its tendency to go up, I feel like there's something here that I'm not yet ready to completely abandon. That, and if I have the funds on hand to cover a 70% drawdown, there's never been a 15 year period where the S&P didn't go up in value - and never a 10 year period where it didn't rise, so long as you bought in the midst of some form of correction.
In the meantime, I will certainly be moving my holdings from SPY to VOO. Thanks for the tip!
