Testing Leveraged Risk Parity Beyond a Favorable Backtest
Summary
The document examines a quarterly rebalanced portfolio that combines leveraged stock and long-term Treasury ETFs to approximate a leveraged risk parity allocation. It cautions that recent performance reflected a favorable stretch in which both asset classes rose, their daily returns were negatively correlated, and volatility did not overwhelm the effects of daily leverage. A longer historical simulation and comparison with simpler allocations are suggested for assessing the strategy.
The analysis distinguishes leverage from improved diversification: leverage can raise potential returns and risk, while the underlying stock and bond mix determines diversification. It highlights sample bias from a long recovery and low-rate period, and explains that simultaneous increases in inflation or discount rates can hurt both holdings. Historical simulations are said to show severe drawdowns and long recoveries, though they may understate extreme losses. The proposed broader risk parity mix includes global equities, government and inflation-linked bonds, commodities, and gold; the discussion notes that suitable geared ETFs may not be available. Historical performance cannot establish future success, especially for a leveraged strategy exposed to changing regimes.
Key ideas
- Leveraged stock and bond ETFs amplify the risks of a basic stock and Treasury allocation without inherently improving its diversification.
- A backtest concentrated in a recovery and low-rate environment may not represent adverse regimes.
- Rising inflation or discount rates can pressure both stocks and bonds at the same time.
- Historical simulations indicate that leveraged allocations can experience deep drawdowns and prolonged recoveries.
- A broader risk parity approach can include inflation-linked bonds, commodities, and gold, though implementation with geared funds may be difficult.
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# Implementing leveraged Risk Parity Portfolio using Direxion 3X ETF # Implementing leveraged Risk Parity Portfolio using Direxion 3X ETF The "common man" version of a leveraged Risk Parity portolio (40% stocks and 60% long term bond, Quarterly Rebalanced) can now be easily implemented using the 3X leveraged ETF's (UPRO=stocks, TMF=bonds). The last ~10 years of performance seems to have benefited from: - A period of rising stock and bond prices - A period of negative correlation of daily stock/bond returns - A period of friendly volatility regime that didn't affect the returns of the daily 3x leveraged ETF's Given that the predictions of doom for long term holders of leveraged ETF's didn't pan out, naive investors might extrapolate the last 10 years of this particular implementation into the future..... QUESTION: How can we properly test and asses the likelihood of future long term success of this portfolio? ## Answer by Helin (score 3, accepted) https://quant.stackexchange.com/a/43976 Apologies in advance for being hyper-critical. I have somewhat strong feelings about this =P - The purpose of risk parity is to improve portfolio efficiency via achieving better diversification. (We won't delve into philosophical debates about whether or not this is true here...) Mechanically, by leveraging up low risk assets (e.g., US Treasuries) and combining them with higher risk assets, you are spreading out the risks, so that the total portfolio risk isn't dominated by equities anymore. - 40% SPY + 60% TLT is a simple risk parity portfolio (although far too simplistic to withstand many shocks; more on this later). Using UPRO and TMF just levers up a risk parity portfolio to boost returns, with associated increase in risks. It's perfectly ok if that's your objective and if you can tolerate the higher risks, but recognize that you haven't improved portfolio efficiency beyond the SPY/TLT combo at all. In fact, your backtest shows Sharpe ratio declined; i.e., for the same unit of risk, you're getting less return. Generally speaking, we should avoid directly comparing two portfolios with very different risk profiles. - The backtest sample is quite biased. It covers just one economic regime – an extended economic recovery. It does not show how the portfolio will perform in adverse environments. The bulk of the sample happens to be a period of zero interest rate & strong monetary stimulations, which boosted stock and bond returns alike. In fact, you can see that the performance has been more subdued over the past few years as the Fed began tightening and there were multiple large drawdowns during a period when a simple 60/40 portfolio did fine. - There are at least two ways to think through how this portfolio might behave going forward: This portfolio intrinsically bets on lower inflation and lower discount rates. If inflation rises and/or discount rate rises, the portfolio will suffer, as both stocks and bonds will struggle. Given that this is likely to be a long-term strategic asset allocation plan, such strong views should probably be avoided, particularly on a levered basis... Predicting the future is hard, but we could at least look at history. The chart below shows the historical drawdowns, based on simple simulations. The light line toward the end of the sample is based on levered ETFs; the darker line is based on 40% 3x levered stocks + 60% 3x levered bonds. We can clearly see some really ugly outcomes and extended periods of drawdowns that the portfolio just struggled to recover from. This is actually a little generous since since it doesn't assume there's a chance of being wiped out completely in some extreme months... ## Answer by Bruno Carneiro (score 2) https://quant.stackexchange.com/a/44270 Here is my take on trying to answer this question. My backtest goes as far as December 1979 (just before the great bond bull run). I used daily total return index for Wilshire 5000 and 10-year constant maturity treasury rates. Remember you can proxy total bond return for $Yield - Duration*\Delta Rate$. Nevertheless, I agree with Helin that this is a less-than-optimal risk parity strategy. Ideally, we would need to include leveraged long-term inflation bonds, commodities, credit spread and breakeven inflation. To the best of my knowledge these asset classes are not available in geared ETFs. A simple unlevered risk parity holds 39% world equities, 14% 20y duration world government bonds, 25% 20y duration world inflation linked bonds, 14% commmodities, and 7% gold. See Bridgewater ppt on page 331. I still haven't figured out how to leverage this simple strategy using tools available to the small investor.
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