Putting Volatility to Work

An investor's biggest risk is falling short of their long term goals. Portfolio volatility can make it uncomfortable maintaining the desired asset allocation in times of stress. Thoughtful asset allocation can reduce volatility, but in addition, risk management should aim to improve long term returns. That's what the Leveraged ETF Allocation Formula (LEAF) strives to accomplish;

to hedge against down markets and to take greater risk in up markets. It aims to maximize returns through the control of risk.

Our tactics were inspired by two charts we reviewed over 15 years ago.

1. The S&P 500 ETF (SPY) vs 20+ Year US Treasuries ETF (TLT)

Both funds made money despite moving in opposite directions almost every day. Why not put volatile, but negatively correlated things together to smooth returns? The model has since expanded to 2 Risk On ETFs (positive correlation to equities) and 7 Risk Off ETFs (negative correlation to equities) as we continue to evaluate the hedging efficiency of all available options.

2. 3x daily S&P 500 (SPXL) Bull vs the -3x daily S&P 500 Bear ETF (SPXS)

BOTH funds lost money over time despite having opposite daily exposures. This is because of volatility drag. To keep their daily leverage ratios constant, they had to buy high on every up day and sell low on every down day.

What if we could rebalance in a way that made market volatility an advantage instead of a drag?

This rebalancing formula is overlaid on the portfolio to reduce risk in overbought conditions, while increasing risk following rapid selloffs.

LEAF combines volatile, negatively correlated assets and utilizes the LEAF algorithm to rebalance (to take advantage of their expected reversion). This underlying concept remains central to how we approach risk management.

This is the first in a series of posts that will form our White Paper. In our next post, we'll cover our Risk On / Risk Off formula.