LEAF - Leveraging Modern Portfolio Theory
- Daniel Morton
- 6 days ago
- 3 min read
In this post we explain how we construct a model that balances "Risk On" ETFs (can perform well in up markets) and "Risk Off" ETFs (can perform well in down markets).
Our current model is made up of two "Risk On" ETFs and seven "Risk Off" ETFs. The model uses US ETFs but is not hedged back to Canadian dollars. The US dollar exposure acts as an eighth hedge. We continually evaluate new ETFs for their possible fit in the model. Risk On
TQQQ ProShares NASDAQ-100
3x the daily performance of the NASDAQ-100
Capital efficient Beta
No tracking error
Low cost
Risk On
SVXY ProShares Short VIX Short-Term Futures
-0.5x daily performance of S&P 500 VIX Short-Term Futures Index
Offers an alternate source of Risk On returns by shorting the VIX futures curve
Can profit in sideways markets
Can improve consistency of returns
Helped minimize losses in NASDAQ-100, during the 2020 selloff, relative to holding 100% of the Risk On position in the NASDAQ-100
Risk Off
ProShares Gold
2x daily performance of the Bloomberg Gold Subindex
Traditional “flight to safety” asset and store of value
Positive long-term return expectation
Very strong contributor YTD
Risk Off
Fidelity Global Value Long / Short
An actively managed Long / Short fund. (up to 150% long / 50% short)
The short positions are typically much more volatile than the long positions, causing a negative correlation to equities
Positive long-term return expectation
Comes with manager specific risk. This is the only non-quant position
Risk Off
ProShares UltraShort Natural Gas
-2x daily performance of the Bloomberg Natural Gas Subindex
Profits from shorting a typically steep futures curve because of the high cost of storing natural gas. The 1x long ETF based on this index loses over 20% per year on average from contango
Unlike shorting a stock, there is a theoretical upper limit on the price of natural gas
Highly volatile. It only requires a small position to be meaningful
Can profit in down markets if energy prices fall
Despite being only slightly positive over 15 years, this is a highly profitable position when rebalanced as part of the model
Risk Off
ProShares VIX Mid-Term Futures
1x daily performance of the S&P 500 VIX Mid-Term Futures Index
Highly reliable hedge (long volatility)
The VIX futures curve is generally flatter further out in time. This usually results in lower roll costs than buying short-term VIX futures.
Despite losing over 90%, it is not a significant drag on returns when rebalanced
Risk Off
CTA Simplify Managed Futures / KraneShares Managed Futures
A systematic futures trading strategy that seeks to profit from trends in commodities and interest rates
Can perform well in significant down markets
Low performance drag in up markets
This is a composite of the KMLM index / ETF before switching to CTA when it goes live in 2022
We preferred CTA's focus on risk management and diversified strategy approach
Added a lot of value to the model in 2020 when many hedges failed
Risk Off
AGF US Market Neutral Anti-Beta
Invests long in U.S. equities with below average betas and shorts securities with above average betas
A very reliable hedge
Low performance drag in up markets
Risk Off
Cambria Tail Risk
A mix of OTM S&P 500 put options and 10 year US Treasuries
A highly reliable hedge
Can perform well in sharp, rapid sell-offs like earlier this year
Statistics
Putting Them Together
The model divides the Risk On and Risk Off positions into two sides. Within each, position sizes are adjusted based on trailing volatility.
There is not risk parity within each side. For example, 3x NASDAQ-100 gets a far larger volatility allocation than -0.5x Short-Term VIX. We found some funds worked better than others and deserved larger allocations.
However, there is risk parity between the two sides, with each allocated half of the model’s projected volatility.
For example, these are the current volatility targets of the model.
Combining these 10 unique exposures, the LEAF model creates a return profile that is greater than the sum of its parts. Indicated below; historical consolidated returns relative to the underlying holdings.
In the next post we will explore smart rebalancing to further enhance returns.
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients. For the past three years, the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your advisor for investment advice.
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