Putting Leverage To Work

I advocate the use of leveraged index vehicles in my stock book and newsletter, such as those offered by ProFunds, ProShares, and Rydex.

Since I first did so five years ago, the strategy has been under attack. The point of attack is always the volatility of the strategies. The inevitable conclusion of the skeptic is that a severe bear market will wipe out the entire investment.

Anything that magnifies performance on the up and down sides will by definition be more volatile than the underlying investment. If you own an ETF or fund that returns 200% of the Dow, then your portfolio will be twice as volatile as the Dow.

Some people equate volatility with risk. It is one kind of risk, but not the only kind and usually not the most important kind. Say you’re 30 years away from retirement. A bank savings account will not fluctuate at all during those 30 years. It will return a few percentage points of interest each year and not for one moment will the balance drop below what you put into the account. It exhibits zero volatility and is therefore not risky at all by this measure.

However, you are guaranteed to miss your retirement goals in that account. The money will not grow enough to meaningfully outpace inflation. In that sense, the bank account is the riskiest choice of all because it comes with a 100% chance of failure to reach your retirement goals.

Volatility, the rise and fall of prices, is not inherently bad. If it ultimately takes your capital to heights not possible without the volatility, then it was worth the rollercoaster ride. Married to the right indexes, leverage and its attendant volatility is an excellent long-term path to wealth.

It works best when combined with dollar-cost averaging. That’s simply sending more money on a regular basis, usually monthly or quarterly. That approach, which happens to be the way most people actually invest, works best with a strategy that is volatile. Why? Because the change in prices is what enables the periodic investments to buy more shares when the price is cheap and fewer when it’s expensive. The automatic result is that the investor ends up with more cheap shares than expensive and benefits when the investment finally rises overall. Stated differently, the average cost of his or her shares is lower than the average cost of the fund or ETF during a given time period.

This can all go terribly wrong if the investment drops to zero and has therefore no chance of recovery, or just drops very low and does not recover. With carefully chosen indexes to leverage, however, these risks diminish. They don’t disappear, but they diminish.

Let’s look at one example. In the 2008 edition of my Neatest Little Guide to Stock Market Investing, I mention that I like the S&P; Midcap 400 index because it tends to rise more than the Dow in good times and fall less in bad times. Look at this chart of the two indexes since August 1991 and you’ll see what I mean.

The period from 1991 to today included one of the worst bear markets in history, that being the dot com bubble burst that took the Nasdaq down some 80%. That’s key to this analysis because critics always point to an awful bear market as the reason that leveraged strategies are doomed to failure.

Even a buy and hold approach to leveraging the S&P; Midcap 400 worked fine in this case, however. Let’s take a big-picture look at how 200% leverage against the index worked over this time period:

  • 08/91 to 01/94: +88%
  • 01/94 to 06/94: -23%
  • 06/94 to 05/96: +96%
  • 05/96 to 07/96: -25%
  • 07/96 to 04/98: +157%
  • 04/98 to 08/98: -50%
  • 08/98 to 08/00: +186%
  • 08/00 to 03/03: -59%
  • 03/03 to 04/06: +220%
  • 04/06 to 07/06: -23%
  • 07/06 to 10/07: +55%

Had you invested $10,000 in the strategy back in August 1991, you would have $122,459 today. Had you invested in the S&P; Midcap 400 index without any leverage, you would have only $71,339. While the strategy did not actually double the index, it did beat it by a wide margin.

Keep in mind that this is buy and hold at work through one of the worst bear markets in history. However, had you been smart enough to keep sending more money each month during those -23%, -25%, -50%, -59%, and -23% times, you would have done considerably better than buy-and-hold alone.

If you were just a tad smarter still and decided to double your monthly contributions whenever the strategy was down by more than 20%, you’d have done better still.

The point to remember is this: extreme volatility coupled with assured recovery is a potent combination. It’s what gives you the confidence needed to send more money to something that is down 59%. You cannot have that confidence in an individual stock because there’s a good chance that it won’t recover or at least won’t do so in a reasonable amount of time.

With an index, though, the situation is different. Indexes always recover. All 30 megacaps on the Dow, all 500 large caps on the S&P; 500, all 400 midcaps on the S&P; Midcap 400 are not going to go bankrupt at the same time. The indexes will have turbulent months and years, as the above history shows, but they will rise to new heights eventually. Confidence in that is what gives an investor the courage needed to pony up more capital during dark months.

To Kelly Letter subscribers, this is old hat. We monitor this approach and use it constantly. It’s been very good to us.

Just recently the familiar saga played out again. During the sub-prime scare last summer, our Maximum Midcap strategy fell 23% from mid-July to mid-August. The predictable “I told you so” mail came pouring in as the headlines darkened around the credit crunch, systemic crisis, worst housing market in decades, and so on.

What did we do? Invested more money with full confidence that the index and our strategy would one day fully recover, as they always have.

Since the August lows, the strategy is already up 21%.

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