So Crazy, It Just Might Work

To close out the week, I wanted to tie my last two posts on sequence of return risk and the use of liquid alternatives together with something of a theoretical portfolio strategy...although it doesn't have to be just theoretical. 

Quickly, sequence of return risk is the risk that the equity market endures a large decline very close, either way, to your chosen retirement date potentially gumming up your retirement plan. 

One way to manage sequence of return risk is to set aside cash to cover some number of months' worth of expected withdrawal needs. "Some number of months" is subjective based on an individual's comfort level. One potential drawback is that too much cash set aside can result in large opportunity cost if you're trying to manage this risk at a time where the stock market rockets higher. 

Another idea is to get equity exposure using leveraged ETFs. For a $100,000 allocation to equities, $50,000 could go into a 2X levered ETF, leaving $50,000 in cash or $33,000 into a 3X levered ETF and putting the rest into cash.

What about tracking error? These funds definitely have a daily objective which can create the effect of "not working" over longer periods, no question about that. But I've looked at this over the years and while the risk that the daily objective conflicts with a longer term result can't be ignored, the reality is it tracks closely far more often than not. 

Here's YTD;

 

Here's two years;

 

Here's a cherry picked where the 3X didn't really work for a while, due I believe to the bounce off the Covid bottom.

 

Play around with the chart to draw your own conclusion. I think they're pretty close most of the time. If you don't think they're close enough then obviously you should not do this trade. 

There's also a know yourself element to this theory. If a 3X levered fund drops 30% in the face of a 10% decline for the S&P 500, how problematic would that be? This year, YTD it's down 50%. This trade still has plenty of cash for expenses and whenever this event is over, the 3X fund will track the market higher even if not perfectly so the strategy is still in tact but down 50% would be tough to look at. I'm not sure I want to find out how problematic that would be for me. Doing this with a 3X fund is probably not my trade.

A 2X fund would be easier to avoid succumbing to emotion but at some point again, the strategy seems crackable emotionally, even if the nuts and bolts work. 

So what then is the point? Although there are none trading yet as best as I can tell, there are 1.5X levered funds in registration.  Using the the same example as before with $100,000 allocation, $66,000 into a 1.5X fund and the rest in cash is a good amount to manage sequence risk, still a lot of cash actually. If such a fund tracked well, then in this decline it might be down 26%-28% and you still have plenty of cash for expenses if you need it, it possible you wouldn't need the cash too.

My plan is to keep an eye out for any broad based 1.5X funds and track them for a bit. If they "work" over periods longer than one day, maybe partition off a few bucks in an account to go 66% into the 1.5X and the rest in something like BIL or other cash proxy to see if it works. If it fails, it would do so incrementally but it might work. 

This post is the start of a portfolio process that could be years down the road for me personally if ever and I think it would need to work for me personally for a while before I considered this in client accounts. 

When I talk about portfolio construction being fascinating to me, this is exactly what I have in mind. I explore this stuff all the time. Exploring is learning.