Using LETFs Combined with the 200 Day Moving Average Trading Approach

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Executive Summary

Leveraged ETFs exaggerate the pattern of the underlying investment.
We cover the common quotes that state this is not good for long-term investing.

Introduction

Leveraged ETFs allow an investor to make a bet on a trend that they have high confidence in. In the paper Leverage for the Long Run, there is an investment strategy that is described that is a very good fit for LETFs. The link for this paper is here.

The Strategy

The strategy is explained as follows.

Part 1: When the S&P 500 Index closes above its Moving Average, rotate into the S&P 500 and use leverage
to magnify returns.
Part 2: When the S&P 500 Index closes below its Moving Average, rotate into Treasury bills to manage risk.

However, one would not have to move out of the market, but instead, one could purchase a leveraged inverse ETF and benefit from the downside or the inverse.

Table 6 of the paper shows the performance of 10 day, 20 day, 50 day, 100 day, and 200 day moving averages. The 10 day is the best at 11.7% and the 200 day is the second best at 10.9 return.

LRS Strategy

The paper then goes on to compare the previously unleveraged strategy, so buying unleveraged ETFs for instance following a 200 day moving average strategy, as described previously, versus a leveraged strategy or a LRS, or leveraged rotational strategy.

The paper describes the results as follows.

As shown in Table 8, as compared to a buy and hold of the S&P 500 and leveraged buy and hold, the LRS achieves: 1) improved absolute returns, 2) lower annualized volatility, 3) improved risk-adjusted returns
(higher Sharpe/Sortino), 4) lower maximum drawdowns, 5) reduced Beta, and 6) significant positive alpha.

The combination of the 200 day moving average strategy combined with the 3x leverage, which could be a 3x leverage fund was the best performing outcome, with a 26.7% annual return. The worst return was the 1.25 levered strategy with a 12.4% return.

The following quote explains some of this.

In Chart 11, we see that this outperformance is consistent over time and through multiple economic and financial market cycles. On average, the LRS outperforms the S&P 500 in 80% of rolling 3-year periods.

Interestingly, because this strategy calls for rotating out of the S&P 500 and into cash or Treasuries, the potential for further increase is possible as an inverse ETF could be used when it is time to rotate from bull to bear.

The Conclusion of the Paper

This is covered in part by the following quotation.

The tremendous wealth generation from stocks over this period, averaging over 9% annualized returns, makes a buy and hold strategy of the S&P 500 extremely difficult to beat. Beyond this, the Efficient Market Hypothesis maintains that it is impossible to consistently outperform the market while Random Walk theory asserts using technical indicators is futile.

Finally, the CAPM states that the only way to achieve a higher return is to take more risk. We challenge each of these theories in this paper. First, we illustrate that Moving Averages and trends contain important information about future volatility and the propensity for streaks in performance.

When the stock market is in an uptrend (above its Moving Average), conditions favor leverage as volatility declines and there are more positive streaks in performance. When the stock market is in a downtrend (below its Moving Average), the opposite is true as volatility tends to rise.

How Moving Averages Are Used by the Paper — As a Signal of What is to Come

Moving Averages are used in this paper as they are simple signals for upcoming market volatility. Besides other Moving Average periods than the 200-Days discussed in this paper, other Risk-On/Risk-Off signals might be applied. In our “2014 Charles H. Dow Award” winning paper “An Intermarket Approach to Beta Rotation,” we look at relative 4-week rolling returns of Utilities sector versus the broad market, a leading signal for market corrections, but also volatility spikes. In our “2014 Wagner Award, 3rd Place” winning “An Intermarket Approach to Tactical Risk Rotation,” relative short to long Treasury index returns are used to predict bullish versus bearish markets (incepted by spikes in the yield spreads).

Conclusion

This strategy looks tantalizing. One wonders if the strategy could be applied outside of the S&P 500.