This is the penultimate installment of the post-2008 wealth creation guide. In part three, I discussed shorting inverse leveraged funds like SPXU and SPXS, which are 3x inverse versions of the S&P 500. As of 7/20/2016, SPXU is trading at 23.50. Shorting $10,000 worth would require shorting 425 shares. If it drops 20% to $18.8, your unrealized profit is $2,000. However, because it’s a 3x fund, if the S&P 500 were to drop 5%, you would lose around $1,500 ~ 435($23.5*1.15-$23.5). The ‘decay formula’ given earlier will give a more exact answer. There is a high degree of path dependency that typicality, over many months, helps the short seller, which is why shorting these leveraged inverse ETFs good strategy in most market conditions.
So the big problem, though, are large loses should the market fall a lot. There is a way around this, to some extent. It’s far from perfect but it helps a lot.
The solution is to buy treasury bonds such as TLT (an ETF proxy for the 30-year treasury bond), which tend to be inversely related to equities. This means if the S&P 500 falls 1% for the day, maybe the 30-year bond will rise .6%, offsetting some of the loss. This results in smoother returns and smaller dips, as shown below:
In 2008, the hypothetical bond-stock portfolio only lost 20-25% vs. a 40% loss for the S&P 500.
Like the S&P 500, bond ETFs pay dividends (about 3% a year for the 30-year bond proxy TLT), and this compounding affect helps immensely. This also helps when you are shorting inverse leveraged bond ETFs like TMV, the inverse 3x version of TLT. Since 30-year bonds pay 3% a year, TMV decays 9% a year just from the yield alone.
Like SPXU and SPXS, the ‘decay formula’ gives an annual decay of around 13% for TMV. Adding the yield decay, and the total is around 20% per year, even for a flat bond market.
Like SPXU, TMV is in a state of constant decay. It cannot retain any of its gains for very long and keeps going lower:
Same for PST, an ETF that is a 2x inverse of the 10-year treasury bond:
Its decay is even smoother than the 30-year one…strait to zero.
So what happens if someone shorts, allocating 50% of the portfolio value to short SPXU and 50% to short TMV, and then rebalancing it quarterly?
Turned $100 into $1,300 after seven years. The sharpe (a measurement of risk-adjusted returns) is about 1.7, twice as good as the S&P 500. This is about as good as any strategy that does not involve exceedingly high leverage. This assumes that bonds and stocks both perform well, but even if they are flat, the 20% annual decay still gives a total compounded return of 250% over seven years. This also ignores transaction costs. When those are factored in, the performance diminishes a little bit.
A common retort is that ‘stocks and bonds have been in a bull market since the early 80s’ but, going as far back to the 1930′s, 10-year T. Bond produce positive yearly returns 80% of the time, according to Annual Returns on Stock, T.Bonds and T.Bills: 1928 – Current.