An Easy Approach to Leveraged Risk Parity Investing

An Easy Approach to Leveraged Risk Parity Investing

When many assets take a sharp tumble, perhaps the hardest thing to do is to recommend investments to make, or to avoid. When the chips are down, what should you do? Apart from selling all your investments and going 100% into cash, that is. Historically, there has never been a long period when staying in cash outperforms investments of any sort. But what investments will do better, and which ones will fare worse? That is something impossible to predict ahead of time. Who would have known that in the 2000s, in the US, a 100% equities portfolio would outperform any combination of stocks and bonds, despite going through 2 sharp stock market downturns? And who would know that in the 2010s, a leveraged risk parity portfolio investing 20% in stocks and 80% in bonds would outperform a 100% equity portfolio (in both cases, absolutely and risk adjusted)?

The state of the financial markets now
When the chips are down and the heavens are falling

So even in the short term, it is hard to foresee how our investments will turn out. And when we are trying to foresee how they will end up in 10 years’ time, all bets are off. We can only join the dots looking back. Who knows if a balanced 60:40 portfolio in stocks and bonds will be the one that does best over 10 years, even while we are looking at rising interest rates and overvalued equity values right now in 2022?

Which is why long term investing can be both surprisingly easy, and infuriatingly hard, compared to trading and investing in response of changes in the economic environment. Easier, because all we have to do is a stick to a simple plan. E.g. pick a diversified portfolio with the highest risk-return tradeoff and stick with it. Harder, because we have to live through agonisingly long periods of market movements without doing anything! It is like watching a train crash in slow motion. But getting started can be easy. Just choose an investment portfolio or approach which has worked both in theory and in history. 10 years from now, it may not have been the best possible investment – we can only join the dots backwards. But given the theoretical and historical evidence, there is good chance that it wold not do too badly.

Revisiting the leveraged risk parity portfolio investing in stocks and bonds

We have previously written on the idea of leveraged risk parity investing:

This idea of leveraging up the low risk assets (bonds) in the portfolio to a level of risk or volatility which is the same as the higher risk assets (equities) is not new. It originated in a series of articles and white papers from the hedge fund managers AQR:

Hence, the idea of leveraged risk parity investing has a long pedigree. But it did not prove itself to be best strategy in the 2000s, although it performed outstanding well in the 2010s. In either case, there was no way anyone could have anticipated how the markets turned out over 10 long years. However, the leveraged risk parity investing approach did not fare too badly in the 2000s compared to the top approach of 100% in equities, so it is a robust investment approach.

Implementing A Leveraged Risk Parity Investment Portfolio

The problem with the leveraged risk party investing approach has always been one of implementation, rather than theory or historical performance. After all, leverage for investments was not accessible to all except for the wealthy back in the 1990s and even early 2000s. Even in the 2010s, when leverage became more widely available, it has been fairly tortuous to build such a portfolio. Namely by:

  • Obtaining a Pledged Asset Line from a bank or broker, and using the borrowed funds plus original capital to construct a stock-bond portfolio
  • Using futures, which limits the investor to the US stocks and bonds for most part (see here for example)

But more recently, an alternative to these methods, in the form of an ETF has been available! This comes in the form of the WisdomTree U.S. Efficient Core Fund ETF NTSX. You can read more about it in their white paper, as well in a review on the Optimized Portfolio blog.

How does the NTSX ETF work?

Basically, the idea behind this ETF is to invest in a portfolio of 90% equities (S&P 500) and 60% bonds (ranging from 2 years to 30 years). Wait a minute … how do we get to 150% in assets in total? Well, the portfolio is leveraged 1.5X in total (or 6X on the bonds), in a way such that the risk or volatility of what is essentially a 60:40 stock-bond portfolio is the same as a 100% equity portfolio. There are some other features of this ETF which make it more attractive than the usual highly specialised ETF.

Some features of the NTSX ETF
NTSX profile for leveraged risk parity investing
Source: Wisdom Tree

Firstly, it has a relatively low expense ratio of 0.2%. Note that this is as a percentage of the Net Asset Value, so essentially, you pay 0.2% on an effective risk exposure of 150%, or 0.13%. Secondly, it has a reasonable fund size of around US$ 1 billion, which means that the expense ratio yields the manager US$ 2 million a year, which is just about sufficient to run the fund effectively. Anything less than that really invites more questions about how viable the ETF will be in the long run. And thirdly, the distribution yield is relatively low at 0.99%, which means less needs to be paid by the investor either as income taxes, or withholding taxes.

In terms of the asset holdings, we can see that the bonds are divided into 5 tranches, ranging from 2 year bonds, to long bonds (which would have taken a beating recently). The equities portion appears to adhere closely to the S&P 500 index.

Asset Allocation fo NTSX
NTSX asset allocation for leveraged risk parity investing
Source: Wisdom Tree

How has the NTSX performed?

But the key question for us would be, how has the NTSX performed? As this ETF was introduced only in mid 2018, there is less than 5 years of history to go on. Still, we can see that over 5 years, it has outperformed the S&P 500 by 58% to 52% (a little only, as expected given the 90% allocation to stocks). And it has done so with the same level of risk, and so the risk-return is better.

NTSX and SPY performance over 5 years
NTSX 5 year performance

The 2 year performance of the NTSX is somewhat worse, underperforming the S&P 500 by 31.5% to 34%. Looking closely at the chart, it appears that the NTSX outperformed in 2020 (due to the sharp fall in bond yields), then lost the advantage in early 2021 (due to rising bond yields) and finally dropped further behind in 2022 (rising bond yields again).

NTSX and SPY performance over 2 years
NTSX 2 year performance
NTSX and SPY performance over 6 months
NTSX 6 month performance

The underperformance is more prominent in the last 6 months, showing how much the rising bond yields have hurt in the near term.

Should I consider NTSX for leveraged risk parity investing?

In the short run, especially in these turbulent times, when the threat of looming interest rate hikes have led to rising bond yields and falling equity prices, NTSX in particular, and leveraged risk parity investing in general, will suffer a double whammy on both equities and bonds. But this is only short term volatility, which may not even continue in the medium term of 2 to 5 years. After all, even with 2 sharp falls in equities in the US (2001 and 2008), a 100% equities portfolio still came out on top. So who knows what will happen with time?

However, as long as we still believe that the fundamental logic behind leveraged risk parity investing is sound, the NTSX offers a convenient entry point to build such a portfolio. If there are any quibbles, it is probably that the leverage in the NTSX is too low. For example, the best performing leveraged portfolio mix in the 2010s was 20% equities to 80% bonds, which requires a lot more leverage. But again, this may not be the winning combination for the 2020s. So a 60:40 mix is a good in-between leveraged position to take.



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