This section is under construction.
Most of the advice here is provisional and subject to further research, but it might be useful, so it's here.
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There are many types of investments beyond the stock and bond portfolios discussed in other sections. These include collectibles like art, wine, coins, and jewelry; real estate; (managed) futures; and hedge funds, which have the freedom to pursue a universe of possible investment approaches such as leveraged buyouts and merger arbitrage. Most people can safely ignore derivatives and alternative asset classes. I've addressed only a few below, either because many people are tempted to invest in them for what I think are incorrect reasons, or because I think they're worth considering for experienced and informed investors. There is a detailed discussion of how to consider using leverage for long-term investing, which is incomplete for now.
Click to skip to each section:
- Real estate investment trusts (REITs)
- New vocabulary
- Managed futures and trend-following
- New allocations
- Black Swans and a Dragon Portfolio
- Gold and other precious metals
- Cryptocurrency
- Leveraged funds
- Options
REITs are companies that own or finance real estate properties and are required to distribute at least 90% of their taxable income to shareholders. Publicly traded REITs give investors liquid exposure to real estate. REITs are already in total stock market funds at a 3-4% weight, so buying REIT funds would mean you're overweighting real estate and underweighting other sectors. Watch this video by Ben Felix on REITs. He argues that overweighting REITs increases exposure to the idiosyncratic risk of the real estate sector without offering a diversification benefit beyond stocks and bonds.
In my view, the best argument for overweighting REITs is that they are very tax-inefficient. This must be priced in, so overweighting them in a tax-advantaged account could be expected to lead to higher returns, because you would be utterly indifferent to taxable distributions. This dynamic is well-established in the municipal bond market, because muni bond income from most bonds issued by your home state is tax-free at the state and federal levels. Their returns are depressed by their potentially tax-free status, so you would never want to own muni bonds in a tax-advantaged account. I recommend against overweighting REITs in a taxable account.
Both Avantis and DFA have real estate ETFs: AVRE (global), DFGR (global), and DFAR (US). Like any ETFs from these managers, they are fairly new, but DFA's mutual fund counterparts DFREX and DFGEX were launched, respectively, in 1993 and 2008. The past performance of DFREX compared to Vanguard's fund is here.
In contrast to total stock market funds like VTI, funds offered by Avantis and DFA have nearly zero exposure to REITs. So if you invest only in their funds like DFAC and AVUV, you'll be underweight real estate. To solve this, you can locate a REIT fund like DFAR in a tax-advantaged account.
REITs are very different than directly owning and managing real estate. While rental income is tax-inefficient because it's taxed as ordinary income and can't be deferred, owning real estate means you can benefit from tax maneuvers like depreciation and 1031 exchanges (although these benefits can be exaggerated). You can leverage through loans, which is often good but can also lead to large losses and even owing more on a property than it's worth. You would need billions of dollars of property to approach the diversification of a fund like DFAR or VNQ. So owning individual properties entails far less diversification and far more idiosyncratic risk than owning a REIT fund. Directly owning property involves a great deal of (potentially stressful) management, or the hiring and payment of property managers.
Many people feel distinctively secure by investing in real estate, especially when they directly own properties. I think there are two main reasons. First, unlike liquid assets, you can't check your phone and see a constantly fluctuating price every day. Real estate is volatile, and the prices of individual properties even more so! But if you can't see the volatility, it feels like a steadier investment. Second, people think that so-called tangible assets like real estate are somehow more insured against poor returns, and that they provide diversification beyond the main liquid assets of stocks and bonds. Real estate prices are positively correlated to stocks, since they both have a strong connection to the health of the economy. As with stocks, real estate buyers tend to pay less when the economy is weak, and the reassuring tangibility of your property can't protect you against that reality. As Ben Felix explained, the evidence indicates that real estate does not diversify a stock and bond portfolio.
In summary, real estate investing is a fine choice if you're motivated to pursue it, but caution is warranted based on the following: (1) REITs are nothing special, and REIT funds are sector funds like any other; (2) the unjustified hype around owning real estate in certain circles is stunning; (3) as with individual stocks, buying individual properties carries a great deal of idiosyncratic risk, with the potential to do much better or much worse than the average real estate investor; (4) taking out loans to buy property entails leveraging that idiosyncratic risk and the possibility of huge losses; and (5) owning real estate is not passive like index funds. Depending on your luck with tenants and property managers, the effort involved can range from years of smooth sailing to enormous frustrations and losses due to bad tenants or incompetent property managers. You can also be affected by policy choices like the COVID-19 eviction moratoriums, which began in the early pandemic and extended in some cases as long as 2023, squeezing landlords whose tenants weren't paying and couldn't be evicted.
Before moving to more sophisticated investments, we should cover a few new terms.
A derivative is a contract whose value is derived from the value of an underlying asset or benchmark, like a stock price. A derivative's value is not fully constrained by the value of the underlying, but that's one of the primary determinants. The main derivatives are options, futures, and swaps. The basics are explained very well by the MoneyWeek videos in those hyperlinks. We'll cover some derivatives below.
An investor who is long on an asset tends to profit when the asset rises in price. The most common way to be long is to own the asset. If you own shares of VTI, then you are long VTI (or long on VTI; either phrasing is fine). Another long position is to buy a call option, which is one type of option we'll cover later.
An investor who is short on an asset tends to profit when it falls in price. You can take a short position by short selling, buying a put option (which is a derivative), or buying an inverse fund (which is not a derivative itself, but the fund uses derivatives). You don't need to know what any of these mean for now.
Recall the discussion of bull markets, in which prices go up, and bear markets, in which prices go down. A long position can also be called bullish, and a short position is bearish.
We've already covered some material that references being long and short. In the stock portfolio section, we discussed various risk factors like the value factor. In that section, it was explained that the value factor is the return of value stocks minus the return of growth stocks. We can use a little jargon now: the value factor is the return of a portfolio that is long value and short growth.
A portfolio that is long value and short growth would still have a large positive return if value stocks returned -10% and growth stocks returned -20%. So the value factor can be positive even if returns for value stocks are negative. QSPRX is a well-known fund that attempts to profit from patterns like this across multiple asset classes. Crucially, this kind of strategy tends to produce returns that are uncorrelated to the returns of the assets themselves. This is called a long-short strategy (also sometimes written as long/short).
One of the major weaknesses of the long-term portfolio I suggested earlier is the risk of unexpectedly high inflation (which tends to be associated with rising interest rates). High inflation is so nasty to most investments that the US government created Series I bonds and TIP securities to help Americans protect their assets. Although long-duration bonds like those held by ZROZ are generally a great diversifier for stocks, they're pummeled when inflation and interest rates rise unexpectedly. The plot below visualizes how stocks and bonds fell together in the inflationary environment of 2022. Compared to short bonds, long bonds are often the better way to counteract downward volatility of stocks with their upward volatility. But long bonds perform far worse during high inflation, and 2022 was especially bad because interest rates rose sharply from very low levels. And although it's widely believed that high-quality bonds consistently perform well when stocks are plummeting — providing "crisis alpha" — this relationship is far from assured even when inflation is normal.
A natural question arises. Is there an asset class we can invest in that diversifies beyond stocks and bonds, that might perform well when stocks and bonds fall? Managed futures can arguably play that role. The main funds we'll cover are KMLM, BLNDX, RSST, and DBMF. Managed futures funds are also called CTA funds, where CTA is commodity trading advisor.
Few people buy managed futures funds because they think their long-term returns will be high as a standalone product. They invest because managed futures can have a strong, positive effect on the risk-adjusted returns of a portfolio, and they can potentially protect a portfolio against tail risk (i.e., disastrous outcomes for assets like stocks and bonds). Except for those heavily invested in long bonds or Russian stocks, 2022 was not a catastrophic year. But year-over-year inflation in the US reached as high as 9.1%, and interest rates rose faster than they have since 1981. As both stocks and bonds fell, funds like KMLM demonstrated their value.
Futures are a derivative, and they're explained in these videos. I don't think a deep understanding of futures is needed to appreciate why a managed futures fund can be valuable to a portfolio. It's important to understand that futures allow a trader to take a long or short position in various markets.
There are two types of momentum used for investing: cross-sectional and time series. Cross-sectional momentum is used in funds like VMOT, where momentum is considered another factor like value. Different asset returns over a lookback period are compared, and the assets are ranked. You take a long position on those with the best momentum, and a short position on those with the worst momentum. Even if all assets had negative recent returns, you would take a long position on those with the least negative returns. So in VMOT, there are long and short positions on different stocks.
In contrast, time series momentum is used in trend-following funds like KMLM. This approach focuses on each asset's own past returns and doesn't compare them to the returns of other assets. It takes a long position if momentum is positive and a short position if momentum is negative. KMLM may go short on UK government bond futures and long on copper futures.
With a time series momentum strategy, you could take a long or short position on all assets. If all assets have positive momentum, you can be long on all of them. With a cross-sectional momentum strategy, there are always long and short positions. Strategies vary in their lookback periods, which range from 1 to 12 months. A strategy may combine multiple lookback periods for greater robustness.
KMLM is an ETF that trend-follows using futures on:
- government bonds from the US, Japan, Germany, UK, and Canada
- commodities (gold, copper, natural gas, heating oil, gasoline, crude oil, corn, wheat, sugar, soybeans, cattle)
- currencies (Euro, British pound, Japanese yen, Canadian dollar, Australian dollar, Swiss franc)
BLNDX has an appropriate ticker: it blends stocks and managed futures into an all-weather portfolio. Part of its portfolio is occupied by cap-weighted developed market stock ETFs (VTI and VEA, and their counterparts at BlackRock, State Street, and Schwab). This part can range from one-third to two-thirds of assets, depending on how stocks are trending. This is combined with managed futures on a wide range of commodities, currencies, bonds, and equities (listed in their brochure). Various interviews with the manager, Eric Crittenden, are on YouTube, of which this one is my favorite.
RSST shares a trait with BLNDX: it stacks managed futures and stocks for a more capital-efficient portfolio. It has a lower expense ratio than BLNDX, and can be traded more easily: BLNDX has a minimum initial investment of $25,000 and transaction fees of $50 at Fidelity and Schwab. RSST has a cousin that combines bonds and managed futures (RSBT).
DBMF is a hedge fund aggregator: it imitates the positions of CTA hedge funds across bonds, commodities, currencies, and equities. A central part of their pitch is that they deliver similar exposure to hedge funds, but with fees that are hundreds of basis points lower. In addition, the aggregation strategy reduces single-manager risk — the idiosyncratic risks of each actively managed CTA hedge fund. This strategy, which relies on condensing active bets by a variety of hedge funds, is quite different than that of KMLM, which largely uses trend-following. Andrew Beer, who co-founded Dynamic Beta, has done many interviews explaining DBMF like this one.
AQR offers various alternative investments, including a managed futures fund. While AQR offers one of the most widely respected funds in this category, the share class with the lowest minimum investment (AQMNX) requires you to put up at least $1 million. So if you allocated (say) 12.5% to this fund, you would need a portfolio of at least $8 million. Or you could invest with an institution, like a wealth management firm or work retirement plan, that can pool the investments of many people. If you have the resources to put a fraction of your portfolio in this fund, you should consider doing so! But we won't focus on this fund.
The net expense ratios of these funds are .85% for DBMF, .92% for KMLM, 1.04% for RSST, and 1.27% for BLNDX. This will probably strike many people as outrageously high. The highest expense ratio of funds suggested so far are the 43 basis points charged by DFEV (Dimensional's emerging markets value ETF), and the 49 basis points charged by IVAL (Alpha Architect's international value ETF).
[More incoming here]
The long-term, high-risk portfolio suggested in the fund section was:
30% VT + 18% AVUV + 12% AVLV + 9% AVDV + 6% AVIV + 5% AVES + 20% GOVZ
We also discussed Alpha Architect products in that section. They hold more concentrated portfolios of 50 equal-weighted stocks, but they offer a way to diversify implementation of value investing. So for a tax-advantaged account, here are possible portfolios with Alpha Architect value funds and a real estate fund:
18% AVUV + 12% AVLV + 10.5% AVDV + 7% AVIV + 7.5% AVES + 11% QVAL + 7% IVAL + 7% AVRE + 20% ZROZ
or
18% DFSV + 12% DFLV + 10.5% DISV + 7% DFIV + 7.5% DFEV + 11% QVAL + 7% IVAL + 7% DFAR + 20% ZROZ
In a taxable account, REIT funds should be eliminated. Both of these portfolios have an acute value tilt and their returns will sometimes deviate greatly from the market (VT). Someone with a large account could invest in Avantis and DFA funds instead of picking only one of them. They could split the allocation to AVUV or DFSV between the two, and do the same with AVLV/DFLV, AVDV/DISV, AVIV/DFIV, and AVES/DFEV. Note that AVRE and DFAR are not as similar as the other pairs, because AVRE is a global fund and DFAR is a US fund. However, more than two-thirds of AVRE's portfolio is in the US.
I'll emphasize that overweighting REITs is a debatable decision. Personally I've chosen to include a small allocation to DFAR in my Roth IRA, due to holding almost no real estate in my other accounts. Because REITs provide high income, foreign tax withholding of dividends makes a global real estate allocation questionable. Apart from not owning AVRE, I split allocations evenly between Avantis and DFA funds.
The portfolios above are divided between two asset classes:
80% stocks + 20% long bonds
We could completely replace bonds with trend-following across asset classes, and Wes Gray (co-founder of Alpha Architect) prefers to only have exposure to bonds through trend. For example:
70% stocks + 15% KMLM + 15% DBMF
Or, imagine you're someone who wants a portfolio that is not quite as focused on aggressive growth, and you want a portfolio that is robust to chaos. Here's a possible allocation that includes managed futures:
50% stocks + 20% RSST + 20% KMLM + 10% ZROZ
In more detail, 50% stocks could be:
12% AVUV/DFSV + 8% AVLV/DFLV + 6% AVDV/DISV + 4% AVIV/DFIV + 8% AVES/DFEV + 8% QVAL + 4% IVAL
You could throw in DBMF if you're comfortable with active management (in this case, the expense ratio is lower than the more passive funds!). Buying shares of BLNDX carries a $50 transaction fee at both Fidelity and Schwab, so it's not a fund you can rebalance into frequently.
Chris Cole of Artemis Capital Management published a paper in January 2020 proposing a 100-year portfolio he called the Dragon Portfolio. By 100-year portfolio, he meant a portfolio that will grow and protect your wealth over all market regimes for the next 100 years, with no adjustment other than rebalancing. You can read the paper here, under "The Allegory of the Hawk and Serpent". The serpent represents regimes of asset growth and great returns for the major risk assets of stocks and bonds (like the 1980s and '90s in the US). The hawk represents various types of chaos, in which one or both of those risk assets perform poorly (like the 1930s and '70s in the US). Together, the hawk and serpent represent cosmic balance and form the dragon.
He stated that conditions between 1980 and 2020 were perfectly suited to high returns for stocks and bonds in the US, and that those conditions are approaching a terminus. The party's over! I don't fully endorse this view, or his 18th-century use of capitalized words, but I think one should always act as if this idea could be right! Ideally, you should be financially prepared at all times to enter a period of unusually poor returns for stocks and bonds. He wrote: "The solution to secular decline is simple when you study financial history: find assets that can perform when Stocks and Bonds don't, and boldly size them in your portfolio regardless of short term performance."
Cole's Dragon Portfolio is composed of five asset classes split evenly: stocks, high-quality long bonds, gold, commodity trend-following, and long volatility. He stated elsewhere that although he back-tested commodity trend, using trend for other assets like bonds also provides diversification. His paper cited the excellent risk-adjusted returns of this portfolio in the US between 1928 and 2019. The max drawdown of the Dragon Portfolio was less than half that of a 60/40 portfolio. A 60/40 portfolio returned an average annual 6.1%, compared to 5.4% for the Dragon Portfolio. They reminded readers that a 60/40 portfolio in the US has been exceptionally successful, and that it's likely not representative of what we should expect in the future.
Although one can tell a compelling story about the diversification value of gold in a back-tested portfolio of US assets, I'm skeptical of how well this can be extrapolated into the future. The far future is another matter entirely. Gold has its own section below, where I describe why I would not include gold in my own Dragon Portfolio.
Long volatility was modeled as an options strategy that follows volatility trends (options are a derivative explained below). Their long vol algorithm was the following: "In our historical simulations, we sought to replicate an Active Long Volatility strategy by buying out-of-the-money put options if the market is down -5% or more and purchasing out-of-the-money call options if the market is up +5% or more over any rolling three months." They wrote that this method optimizes for simplicity, and is expected to be suboptimal in terms of performance. Data from options exchanges extend back to the 1980s. They extrapolated from real data to simulate a long vol strategy throughout the entire period of 1928-2019. The long vol approach is intended to produce explosive movements that sometimes have negative correlation to stocks.
Despite the simulation of a long vol option buying back-test, I'm skeptical of the value of this part of the Dragon Portfolio. It naturally loses money most of the time, but is primarily meant to benefit the investor by providing capital to rebalance into stocks when they have plummeted (which is the most valuable time to buy stocks). However, much of the time, an investor would have benefited from simply investing this portion in short-term US Treasury bills and building a cash reserve to invest when other parts of the portfolio have crashed. I think it's important to note that if you access a long vol strategy through hedge funds, which is what Cole recommends, your total fees will average multiple percentage points annually. Given the limited real data on which to test long vol strategies and the high fees of professional managers, I would be reluctant to include it in my Dragon Portfolio.
Before landing in Australia, Europeans had encountered only white swans. In his well-known book, Nassim Taleb defined a proverbial "black swan" as an outlier which couldn't have been predicted on the basis of prior observation, which has an extreme impact — unlike the bird — and which humans try to explain afterward (often convincing themselves that it was predictable). Black swans are not merely surprising events, like the COVID-19 pandemic, because experts on infectious disease were aware of the risk, even if they couldn't predict when the next major pandemic would occur. One could argue that the 9/11 attacks were a black swan.
Reducing the Risk of Black Swans, by Larry Swedroe and Kevin Grogan, explores how to diversify in ways that reduce risk in a fundamentally unpredictable future. Finding imperfectly correlated assets is the heart of diversification. A portfolio with uncorrelated assets that each have high expected return would be ideal. But how could we achieve equity-like returns that aren't highly correlated with equities? The book seeks to answer this question. Unfortunately, most of these assets are accessible only to institutional investors, very high net worth investors, and clients of certain wealth management firms. They require high minimum investments and are partly illiquid, which is why access is restricted. Some of the funds are interval funds, which differ from mutual funds because (a) they have quarterly liquidity instead of daily liquidity and (b) redemptions are limited, so it takes time to withdraw your entire investment. What are the alternative investments they suggest?
Alternative lending invests in student loans, small business loans, and others facilitated by non-traditional lenders. It tends to have low duration risk combined with higher credit risk than A-rated corporate bonds. Their recommended fund, LENDX from Stone Ridge, has a minimum investment of $15 million, so investors typically access the fund through wealth management firms or other institutions. Although you might suspect that the returns of LENDX look like those of a corporate bond fund, the returns in their prospectus exhibit very different behavior.
Reinsurance is insurance purchased by an insurance company, to expand the client base they can insure while responsibly managing risk. Losses due to insured events like earthquakes and hurricanes are expected to be highly distinct from stock market downturns. Catastrophe bonds, commonly shortened to cat bonds, are bonds that reward investors when insured disasters do not occur. A good reinsurance fund is diversified across many sources of risk, of which cat bonds are only one. The fund they recommend for reinsurance is SRRIX from Stone Ridge.
From an expected value standpoint, people are willing to overpay for hedges against catastrophic outcomes (insurance) and for extreme upside opportunities (lotteries). In other words, it is profitable to sell volatility. They refer to this risk premium as the variance risk premium (VRP). Short vol strategies tend to be risky. An investor who sells options on equities will suffer large drawdowns in the worst economic periods, when most people aren't capable of accepting extra risk. They recommend AVRPX, the Stone Ridge All Asset Variance Risk Premium Interval Fund, which no longer exists. Stone Ridge does offer VRLIX, but it runs a narrower and less useful strategy than AVRPX, simply selling put options on equity indices. However, Stone Ridge has a multi-strategy fund, which includes a multi-asset VRP strategy among several others. Short vol equity strategies are not a diversifier.
Long-short risk premia strategies allow an investor to profit by taking a long position on certain assets with a higher expected return, and a short position on others with a lower expected return. A portfolio that is long value stocks and short growth stocks is expected to have positive returns with low correlation to stocks and bonds. QSPRX from AQR is the fund they recommend for risk premia strategies across multiple asset classes.
Time-series momentum, or trend-following, is generally implemented using futures, leading to the broad category of "managed futures". As discussed above, trend-following across multiple asset classes has returns with very low correlation to stocks and bonds. They recommend AQMRX and QMHRX, which are AQR funds with high minimum investments.
In an appendix, they discuss whether REITs add diversification. They review one of the same studies that Ben Felix covered, and note that REITs have historically been highly correlated with a portfolio of small cap value stocks and corporate bonds. Their conclusion is the same as Felix's: there is little reason to overweight REITs beyond market cap weights.
All of these strategies are less tax-efficient and charge higher fees than buying and holding a stock ETF. Still, the diversification provided by some of them is impressive.
We've now reviewed a number of sources of risk and expected return:
- Stocks
- Bonds
- Real estate
- Trend-following (bonds, commodities, currencies, equities)
- Long vol option buying
- Short vol option selling
- Commodities (notably gold)
- Alternative lending
- Reinsurance (e.g., cat bonds)
- Long-short risk factor portfolios
- Merger and convertible arbitrage
I'll give small cap value stocks an honorable mention, since they sometimes behave quite differently than cap-weighted stocks. But their sources of risk and expected return are fundamentally similar, whereas long-short strategies provide unadulterated access to risk premia like the value premium. The diversification added by real estate is questionable.
Returns from merger arbitrage have low correlation to returns from stocks or other asset classes during most market conditions. But merger deals are more likely to fall through due to economic downturns when an acquiring company is no longer satisfied with a deal that was agreed upon during better economic conditions. So merger arbitrage does not always diversify much during stock crashes, which is mainly when we want uncorrelated returns. Convertible arbitrage is another category, although both of these terms abuse the definition of "arbitrage", which is supposed to mean risk-free profit. The textbook example of real arbitrage is discovering different prices for the same security listed on multiple exchanges. If the price is $110.15 on the NYSE and $110.20 on the LSE and the bid-ask spread is two cents, you can buy on the NYSE and sell on the LSE until the difference equals the spread. As you can see from the returns of MERFX, ADAIX, and MNA, arbitrage strategies have sometimes (but not always) reduced losses during recent bear markets. See here for a comparison of MERFX and intermediate US Treasury bonds, which shows that MERFX has sometimes provided incremental diversification to a portfolio with high-quality bonds.
Option buying and option selling are two sides of a trade. When it comes to equity, you have to pick one side. I think Chris Cole is correct that a long vol strategy makes a portfolio more robust. Short vol equity strategies make a portfolio more brittle. AVRPX, the fund suggested by Swedroe, appears to have used a strategy diversified across asset classes. But VRLIX focuses on selling equity put options, which means it's highly exposed to market downturns. VRLIX is strongly correlated with a long equity portfolio, and provides little diversification while charging high fees.
I think those who have the resources to invest in reinsurance, alternative lending, long-short risk premia, and arbitrage strategies should consider doing so, since they provide meaningful diversification. Personally I am most persuaded by the value of reinsurance. If I were invested in a fund like QSPRX that targets a long-short value premium (among other premia), I would reduce the value tilt in my long stock portfolio, since QSPRX increases exposure to that risk premium. Those without access to these alternatives — a vast majority of investors — can create a robust portfolio with managed futures, bonds, and factor-tilted stocks. I would be happy to lock in a 100-year portfolio with something like the final portfolio suggested above.
There are a few reasons people invest in gold. They may think it is a widely recognized store of value (correctly, of course); that it is a reliable hedge against inflation or economic downturns; or that it will be useful as currency during a potential societal collapse because of its intrinsic value.
Unfortunately, gold is not a good store of value compared to (say) holding cash equivalents in a stable currency like the US dollar. Gold is a volatile asset that can lose value for long periods and has experienced no positive real return over its many centuries of use. Although it has acted as an inflation hedge over centuries, the price is so volatile that it can fall behind or run ahead of inflation for decades. So it's not a reliable hedge against inflation over timespans that most human investors care about. Its value sometimes increases when unexpected inflation occurs, and sometimes decreases. Anecdotally, when inflation spiked globally in 2021-22, the price of gold trended downward. In addition, buying and selling physical gold carries high transaction costs. For evidence and more information, you could read these papers or watch videos here, here, and here.
Much of the back-tested data showing the diversification provided by gold occurred when the US dollar and other currencies were linked at various times to a gold standard. The best decade for gold was the 1970s, immediately after the convertibility of the US dollar to gold ended in 1971. US cap-weighted stocks had a poor decade of returns, while gold exploded in price. Is it reasonable to expect gold to act as such a great diversifier in the future? Could there be another period like the '70s? Personally, I'm unconvinced that we should expect a repeat performance by gold, and that it deserves 20% allocation in a 100-year Dragon Portfolio.
In this interview on the Rational Reminder, Dr. Campbell Harvey discussed a fascinating interaction he had with someone who managed a family trust with an investment horizon of hundreds of years. He also mentioned the possibility that gold could lose significant value in the long run due to asteroid mining, which is a real prospect in the next several decades. Moving mass between the ground and orbit has become drastically cheaper due to reusable rockets, and it's a matter of time before nudging an asteroid into distant orbit around Earth and extracting rare metals becomes a profitable business. For this reason, I would exclude gold as a buy-and-hold investment from a literal 100-year portfolio. I think it's hard to avoid the conclusion that once asteroid mining becomes viable, the status of gold as a universal store of value will be destroyed. The unique role of gold has always relied on its scarcity. Abundance will transform gold into a common industrial metal like copper. Other useful rare metals will also become abundant, which will be great for all of humanity.
In my view, aside from making specific bets on price movement or mechanically trend-following, for most people there is one good reason to own gold: to protect your wealth against a collapse of the value of your home country's currency. For US citizens, this is not a major concern: USD is the global reserve currency and inflation is sufficiently low and stable. For someone in a country like Venezuela, Turkey, or Argentina, wealth is vulnerable to hyperinflation and the loss of their currency's value relative to other currencies. If they have access, they could simply hold other currencies or assets like US-listed securities. If not, they could own gold or a USD stablecoin, the latter of which is the only application of cryptocurrency I would consider suggesting to most people (see below).
If you're not concerned with inflation or diversification, but instead with currency that people will value during an apocalypse, I suggest expanding your portfolio of canned food, water filters, medical supplies, guns, bullets, and empty polyethylene cans (for panic-hoarding gasoline when the moment arrives). I personally find it doubtful that anyone will accept gold coins and bars in exchange for a resource of real value at the end of the world. Gold may have widely recognized value during normal times, but it does not have intrinsic value, except for certain engineering applications which don't apply to a vast majority of people. Even if you found the one fool willing to give you food in exchange for yellow metal, the difficulty of distinguishing real gold from counterfeit gold presents yet another challenge. Most people would not know how to do that, especially under conditions of societal collapse with no way to look it up on the internet.
So unless you're interested in trend-following or speculative trading, I don't recommend precious metals. If you'd like to hedge against unexpectedly high inflation, you can buy treasury inflation-protected securities. If you want good returns during high inflation, you can invest in Series I savings bonds.
This column from the WSJ describes the main issue with investing in cryptocurrencies that I'd like to express. Even if some cryptocurrencies appreciate greatly in value, the distribution of returns is almost certain to be highly positively skewed. Unless you're determined to build a diversified portfolio of cryptocurrencies on your own, there is a high risk of missing out on the appreciation of a small fraction of cryptocurrencies. This is a crucial lesson in stocks as well: the positively skewed distribution of returns is why you need to diversify broadly to avoid the risk of underperformance. Someone holding only a few stocks or a few cryptocurrencies bears a high risk of underperforming the asset class return. On top of that, there is no guarantee that cryptocurrency will have a positive asset class return, regardless of your time horizon. Of course, anyone is free to bet on specific cryptocurrencies, but the advice given in this guide is deliberately not reliant on being smarter than everyone else.
A USD stablecoin like USD Coin enables someone to own a cryptocurrency that is redeemable for USD, even if they lack access to financial institutions that would allow them to hold USD. A refugee fleeing their country with nothing but their private key could convert USD Coin (USDC) to fiat currency once they arrived somewhere with banking institutions (or found someone willing to exchange cash for crypto). Ukrainian refugees fleeing to Poland actually did this during the Russian invasion in February 2022, because banking access had been obstructed and many people had to flee without the money in their bank accounts. Poland has many Bitcoin ATMs, which allowed those without any banking access in Poland to convert their cryptocurrency to cash.
Stablecoins pegged to the value of a currency, most notably the US dollar but also the Euro and Japanese yen, are important because they facilitate international transactions that traditional financial institutions can make extremely difficult. This highlights that the only major use case for cryptocurrencies so far has been to sidestep regulations that govern traditional banking and investments. A stablecoin is the only application of cryptocurrency I might currently recommend to people who aren't already interested for some other reason, especially if you live in a country with an unstable currency or you want to use them for international transactions. However, you still need to understand different kinds of stablecoins. Some stablecoins are built poorly and are not stable at all. Cryptocurrency skeptics might say that you have no assurance that even the asset-backed stablecoins are actually asset-backed. Given the amount of fraud in the crypto space, I can't strongly disagree until regulators start verifying these assets. The consortium that runs USDC states that it's backed by cash and US Treasury bonds. Even USDC briefly lost its dollar peg after the failure of Silicon Valley Bank, where cash reserves backing the coin were held. Had all depositors not been promptly and fully backstopped by the government, that incident could've been more severe.
The sections below on leverage are half-baked for now, but they contain some possibly useful thoughts on the use of leverage in a long-term portfolio.
In 2006, the SEC finally permitted the creation of highly leveraged funds, and asset managers like Direxion and ProShares have since launched well over 100 leveraged ETFs. Some of them were listed in the midst of the stock market's recovery from the 2008 financial crisis. This turned out to be impeccable timing, because the 2010s witnessed a spectacular bull market for US stocks, in particular tech stocks. Additionally, interest rates have been low since 2009, minimizing the cost of using derivatives to lever up the returns. The leveraged fund with the largest AUM is TQQQ. It's named after QQQ, which tracks the tech-heavy Nasdaq 100 index. The fund uses derivatives to produce three times the daily returns of the Nasdaq 100. If QQQ increases 1% tomorrow, TQQQ will increase by about 3%. If QQQ falls by 2%, TQQQ will fall by about 6%.[1]
From inception in February 2010 through the end of 2021, the average annualized return of TQQQ was roughly 55%. An investor who bought shares at the end of Feb 2010 and sold at the end of Dec 2021 would've multiplied their money by about 179.[2] These are eye-watering, brain-shattering, hair-on-fire returns. Who wouldn't want to invest in TQQQ?
We don't have to move into wild hypotheticals to see how a triple-leveraged fund can be hazardous. It's notable that TQQQ was fortunate enough to incept in 2010, meaning that so far it has never experienced a major, prolonged drawdown for US stocks. (TQQQ fell by 69.9% during the COVID crash, but the market quickly recovered.) However, QQQ was created in March 1999. What if we simply back up the clock and infer the returns of TQQQ from QQQ? What would have happened during the implosion of the tech bubble in the early 2000s?[3]
From inception to its lowest point in 2002, QQQ fell by 60.7%. TQQQ would have experienced a decline of about 99.7% in the same period. From its peak, QQQ drew down by 83.0%, while TQQQ would have fallen by about 99.97%. TQQQ investors would have lost virtually everything, and the fund arguably would have closed down. Had TQQQ been launched alongside QQQ and stayed open, the return since inception of QQQ would be superior to that of TQQQ.
Part of the problem with TQQQ is that it's concentrated in tech stocks. Under-diversification leaves it needlessly vulnerable to large drawdowns. Just recently, between Nov 2021 and Dec 2022, tech stocks were routed and it fell by 81.7%. An investor seeking high expected return could allocate a fraction of their portfolio to a leveraged ETF, and rebalance when its weight deviates significantly from its intended weight. But as I'll explain in the next section, options offer an alternative form of leverage. Click here for a direct comparison and more (very important!) information on leveraged ETFs.
Options are a derivative, which means they derive their value from the price of an underlying security, like a stock or an ETF. They are complex — much harder to understand than a stock or bond fund. So I don't expect a reader to feel like they have a complete understanding of how to invest in options after reading the section below. Before or after reading the written information, it will help to watch videos. This video is a good explanation of the basics, and this video is a detailed tutorial on how options work. Combining this with the written suggestions below will help with digesting this dense material. Understanding options is not easy and will require multiple hours of effort to reach a point at which you can think about how to include them in your portfolio.
- Introduction to options
- An option’s value
- Example
- Calculating the breakeven price
- Risk management
- Which ETFs?
- Practical information
- ETF call options or leveraged ETFs?
Before explaining what options are, I think it will be useful to describe why we would consider using them. Options can be used to increase leverage on a position, to hedge the risk of an existing position, and to establish complex risk profiles. You can even use options to bet that volatility will be lower than the market expects. This isn't a bet you can make by purchasing or selling the security itself.
In the section on risk, we discussed the distinction between compensated and uncompensated risk. And in the section on building a stock portfolio, we discussed how to systematically invest in riskier stocks in order to increase our expected return. This is a way of taking compensated risk, which is the kind of risk we want. But how could we take even more compensated risk than owning stock funds — which are already quite volatile — with the hope of greater long-term returns? Buying stock is a bet that the stock portfolio will have positive returns, and buying options is a way to make a more extreme bet that those shares will have positive returns. This is a form of leverage: a correct prediction can yield much greater gains, and an incorrect one can cause large losses.
So what is an option? It’s a contract between you and another person, who is called the "counterparty" because they’re taking the other side of the trade. The value of the contract is based partly on the value of an underlying security, like an ETF. There are different types of options, but we’ll focus on only one type, a call option. We’ll make up an ETF with the ticker “XY”. If we buy a call option on XY, the contract would provide us with certain rights.
For each call option contract we buy, we acquire the right to buy 100 shares of XY from the counterparty at an agreed-upon price anytime before an agreed-upon expiration date. The option has a cost, called the premium, because we pay the counterparty for these valuable rights. The agreed-upon price at which we can buy XY is an important aspect of the option, because being able to buy shares at a lower price makes the option more valuable. The agreed-upon price is called the "strike price". The expiration date is another important aspect, because a more distant expiration date gives XY more time to increase in value. At any time, the owner of a call option can exercise it and buy 100 shares per contract from the counterparty at the strike price. They can also sell the option to someone else anytime during market hours. In this example, XY is the "underlying" because the value of an XY option is influenced by the price of XY. An option always controls exactly 100 shares of the underlying.
How is the value of an option determined? Like any other security, the market decides on the prevailing price through negotiation between buyers and sellers. But as always, the characteristics of the security act as constraints. An option’s value is divided between intrinsic and extrinsic value. Intrinsic value is simple: if an option’s strike price is below the current market price, the option has intrinsic value. Let’s say the option’s strike price is $150 and the market price is $200. That means we can exercise the option, buy the shares at $150 and sell them at $200. The $50 profit would be multiplied by 100 shares per contract. That’s the nature of intrinsic value.
But even an option whose strike price is greater than the market price has value. We call it extrinsic value, because it reflects the potential for an option to acquire intrinsic value (or gain more than it already has) before expiration. If the strike price were $150 and the market price were $140, there would be no value in exercising the option presently. But it has extrinsic value because the market price may rise above $150 before expiration. An option with a strike price less than the market price is “in the money” (ITM); an option with a strike price greater than the market price is “out of the money” (OTM); and an option with a strike price close to the market price is “at the money” (ATM). As silly as it sounds, this variable is called "moneyness". An in-the-money option has intrinsic value because it could be exercised profitably right now, while an out-of-the-money option does not. The value of an OTM option is entirely composed of extrinsic value (also known as time value). An ITM option has both intrinsic and extrinsic value.
Let’s make this more concrete. It’s November 2023, and we own shares of XY, but we’d also like to gain leverage on our expectation that XY’s share price will rise. So we buy call options on XY that expire on January 20, 2025. Let’s say the current share price of XY is $50. For reasons I’ll explain below, we want to buy an in-the-money (ITM) option. So we check the price of XY call options expiring on January 20, 2025 with a strike price of $45. The ask price of the option's premium is $7.41, which refers to the cost per share. To calculate the cost per contract, we multiply by 100 to find that the cost of buying a contract is $741.
How much could we profit or lose from this option? Let’s say that by the expiration date, XY’s price has increased by 10% to $55. Our strike price is $45, so we exercise on the expiration date and buy 100 shares for $45. We sell them immediately for $55, making $10 per share and a total of $1,000. Our profit is $259: $1,000 minus the $741 premium. We can compare this to buying shares with the same amount of money: $741 of shares would’ve increased in value by 10% or $74.10.
Note that we’re referring to XY’s price and not its total return. An owner of the underlying receives dividends, whereas an owner of a call option does not. So if XY’s price increased by 10%, an investor in XY shares would’ve gained slightly more. Keep the lack of dividends in mind when considering possible returns of a call option.
Let’s consider the potential downside of an option. Imagine that XY’s share price has fallen 16% to $42 by the expiration date. Because $42 is less than the strike price of $45, the option expires worthless. The loss would be the value of the contract we purchased: $741. Buying shares with the same $741 would have produced a loss of only $118.56 (minus reinvested dividends).
There are more ways to lose money with options than a total loss due to OTM expiration. Imagine that by expiration, XY has appreciated by only 2% to $51. We exercise the option, buying shares at $45 and selling at $51, netting $6 per share and a total of $600. But wait, we paid $741 for this option! So we actually lost $141. Not only that, but if we had bought $741 of shares instead, we would’ve made $14.82 from price appreciation and some more from dividends. The $141 + $14.82 + dividends is an opportunity cost: we would've profited by purchasing shares instead of an option.
The last situation is good for the counterparty. They’re likely holding 100 shares of XY for every contract they sell you. So they benefit from the dividends and the $741 premium you paid for the contract. They sell those 100 shares to you at a discounted price when you exercise, but your ability to buy shares at $45 and make $600 is more than compensated by the $741 premium they received over a year prior. It would be very risky for the counterparty to not hold 100 shares per contract they sell, because they would otherwise be exposed to unlimited losses. Selling a call while you hold the underlying is known as selling a covered call.[4]
Let's dissect how the option is valued in this last example. The premium was $741 and, when we purchased it, the option had $500 of intrinsic value: $50 - $45 = $5 per share, and we multiply by 100 shares. This implies that it had $741 - $500 = $241 of extrinsic value. The option gained intrinsic value by expiration: $51 - $45 = $6 per share, giving it an intrinsic value of $600. But because it was the day of expiration, the option had no extrinsic value remaining. Even though intrinsic value increased while we held the option, we lost money because extrinsic value decreased by a greater amount. We can imagine an alternative example where XY reached a price of $51 three months before expiration. At that time, we could decide to sell the option for more than $600. We know the option's extrinsic value would be greater than zero, because it reflects the potential for more growth in the three months before expiration.
An important price you should be able to calculate before buying an option is the breakeven price. This is the price the underlying needs to reach by expiration for you to break even. We paid $7.41 per share for the option with a strike price of $45 when XY's price was $50. In order to break even, the act of exercising needs to generate the same value as the premium we paid, which was $741. So the price would need to rise to $45 + $7.41 = $52.41, which is a 4.82% increase from $50. Of course, if the option expires at the breakeven price or slightly above, we would've profited more by investing in shares instead, so this doesn't consider the opportunity cost. Remember that in the last example above, we lost money because XY had increased to a price of only $51, which is less than the breakeven price of $52.41.
The breakeven price is important not just for understanding a given option, but for comparing different options. If we buy an ITM option with a strike price of $45 while the market price is $50, that option is 10% ITM: (50-45)/50 = .1 = 10%. If we were to buy a 20% ITM option with a strike price of $40, the breakeven price would be significantly lower. The option would also carry a lower risk of expiring worthless. However, the premium would be more expensive. In contrast, an at-the-money (ATM) option with a strike price of $50 would have a higher breakeven price than an ITM option. An OTM option with a strike price of $55 would be even cheaper, but it would have a breakeven price that is higher still. The 10% OTM option might have a premium of only $220. But that would make the breakeven price $55 + $2.20 = $57.20, which is a 14.4% increase from $50. So anyone who buys an OTM contract is betting on high returns for the underlying. Options that are deeper in the money are less risky and have higher premiums; options that are further out of the money are riskier and have lower premiums.
For most investors who want to lever up by buying call options, I think it's sensible to buy long-dated options with breakeven prices that anticipate modest returns, like the 10% ITM option with a breakeven increase of 4.82% and expiration in 14 months. Buying OTM options is risky and can easily lead to major losses, including total loss.
Risk management with this approach to options is relatively simple. The first aspect is appropriate position sizing. Even for someone with a high risk tolerance and a 30-year time horizon, I don't recommend occupying more than 15% of your portfolio with options. In a portfolio with 90% stock funds and 10% ETF call options, the options will generate at least as much volatility as the stock funds despite being a much smaller portion. Exceeding 20% of your portfolio would be very risky, unless you're buying deep ITM options (as Nancy Pelosi often does).
In addition to position sizing, rebalancing is crucial. If the underlying securities perform very well in a given year, your options are likely to expand to a larger part of the portfolio. This expansion could keep occurring for years in a long bull market, but you should not allow it. There is no way to reliably predict it, but eventually the underlying ETFs will experience a deep, prolonged drawdown. Their prices will fall below the strike prices of your options, and the options will expire worthless. This is why, regardless of risk tolerance, no one should ever invest 100% of their portfolio in options (or highly leveraged ETFs, as we saw with TQQQ and the tech bubble).
Disciplined rebalancing needs to occur when options thrive and when they die. In a spectacular year when your options expand from 10% to 25% of your portfolio, it's important to restrain yourself. When you sell the options, do not invest all that money into more options. Reinvest 10% of the value of your portfolio in options, and the rest into your stock funds (assuming 10% is your intended allocation). Otherwise, the allocation to options could keep expanding until one year, your options finally expire worthless and blow up a third of your portfolio, erasing all the leveraged gains.
On the other hand, when your options expire worthless during a bear market, it's important not to let the disappointment and regret deter you from persisting. If all your options expired worthless, rebalance them from 0% back to 10% (again, assuming 10% is the intended weight). If you rebalance correctly year after year, the options will occasionally go to zero, but your portfolio will be much larger in the long run. The stock funds are a way to secure your leveraged gains when they succeed, and they serve as fuel for more gains when your options evaporate.
Most people do not have the risk tolerance or the cold discipline for this approach. A leveraged portfolio will add undue stress to your life if you're unable to detach yourself from the daily volatility and focus on the soundness of the process. Carefully consider whether you have the right disposition.
Many ETFs have option markets (mutual funds do not). Ideally, I could invest in my favorite portfolio of ETFs and buy call options on the same ETFs. But options are not like ETFs, where bid-ask spreads are negligible for long-term investors. Bid-ask spreads on an ETF that isn't especially popular might be 0.1% or 0.2%, but this is insignificant because it's still a small spread and you can hold for a long time. Liquidity becomes a very important consideration for options because you can't hold for an indefinite duration and, more importantly, spreads on ETFs with very little options activity can be abysmal. It's not hard to find an ETF that has some options with 50% bid-ask spreads. Options with the same underlying can differ greatly in liquidity, because options that are currently being traded less frequently have larger spreads. These tend to be options with more distant expiration dates and strike prices that are further from the market price (deep ITM or OTM).
So we can't simply pick our favorite ETFs. AVUV has a thinly traded option market with wide spreads, and AVES is so new that there is no option trading. We have to narrow our focus to ETFs with large AUM and high trading volume, which tend to be provided by large asset managers like Vanguard, BlackRock, State Street, and Invesco. Not only do ETFs with more active option markets have smaller spreads, they also have a larger number of available expiration dates.
Let's start with exposure to cap-weighted equity. The most liquid option market in the world is SPY, an S&P 500 ETF managed by State Street. This is a good enough representation of cap-weighted US equity to use for call options. The main drawback is not that SPY includes only 500 stocks, but that SPY has a share price over $400. Long-dated call options on an ETF with such a high share price are several thousand dollars for a single contract, which is an obstacle for small investors. VTI, Vanguard's total US stock ETF, has a lower share price and a very liquid option market. For developed markets outside the US, EFA has by far the most liquid options. It does not include Canada, but Canada occupies only 3% of global market capitalization.
For emerging markets, EEM has the most actively traded options. However, it has an expense ratio of 0.68%, so VWO, Vanguard's emerging markets ETF with an expense ratio of 0.08%, may be a good substitute. EEM has a larger selection of expiration dates, but if there is a VWO option with a similar bid-ask spread and an expiration date suitable for your portfolio, it is probably a better fund. The same applies to IEMG, although its expiration dates are even more limited than those of VWO. VWO does not include South Korea but EEM and IEMG do, so an options portfolio with EFA and VWO will omit South Korea. For a much lower expense ratio, this is arguably an acceptable drawback. IWN has the most liquid options for US small cap value.
So we can build a globally diversified portfolio with SPY or VTI for US equity; EFA for developed ex-North America equity; EEM, VWO or IEMG for emerging markets equity; and IWN for US small cap value stocks.
The explanation above described options as if the goal were to exercise them. An option is indeed valuable because of the owner's right to exercise it, but most people who buy an option don't exercise it — they sell it. Practically, you probably will not have enough money in your account to exercise a call option without liquidating other assets. In the example above with XY, we bought a call option with a strike price of $45, which means that buying 100 shares would require $4,500. Rather than coming up with that much money, it usually makes more sense to sell the option before expiration (in this case, before market close on Jan 20 2025).
You don't have to wait until the day of expiration to sell an option. As I mentioned above, options with closer expiration dates tend to be more liquid, so waiting until expiration is within a week will probably grant you the smallest bid-ask spread. You could also roll the expiration dates much sooner. For example, we bought the XY option in November 2023, 14 months before expiration. We could sell it three months before expiration in October 2024 and roll to an XY call option expiring on Jan 20 2026. Neither is inherently better, but rolling before the final month avoids the comparatively rapid decay of extrinsic value that tends to occur as expiration approaches.
When trading options, the possible actions are not just "buy" and "sell". They are "buy to open", "buy to close", "sell to open", and "sell to close". The strategy discussed above is called a "long call", and for that you need only two actions: "buy to open" when you buy the option and open the position, then "sell to close" when you sell the option. "Exercise" is a fifth possible action and will close a long call position but, as mentioned, it's rare that this is appropriate. Some brokers make it hard to exercise because they don't want people to unwittingly squander the extrinsic value of the option. If you plan to exercise, ensure that you find out in advance exactly how to exercise an option with your broker.
Like applying for margin, you have to apply for option trading. Brokers distinguish between different types of option trades, based on how potentially risky the types of trades are. Long calls are a relatively low-risk strategy. Fidelity separates option trading into Levels 1 through 5, and to run this strategy you need Level 2. Schwab has Levels 0 through 3, and to run this strategy you need Level 1.
While most brokers have eliminated commissions for stocks and ETFs, each purchase or sale of an option has a commission of $0.65 per contract. This is negligible compared to the price of any long-dated option.
More incoming: automatic exercise after end of day on expiration date; automatic selling if not enough cash in account; when to exercise an option; rolling an option by selling and buying simultaneously; liquidity near market open and close.
This section is disorganized for now. More incoming.
We discussed above how we could build a portfolio of ETF call options, perhaps VTI + EFA + VWO + IWN. Could we build a similar portfolio with leveraged ETFs? We could achieve 2x daily exposure to the S&P 500 (SSO/SPUU), developed ex-North America markets (EFO), and emerging markets (EET). We could also achieve 3x daily exposure to the S&P 500 (UPRO/SPXL) and emerging markets (EDC), but not developed ex-US markets since Direxion liquidated DZK in 2020. There are no LETFs with small cap value exposure. Since small cap value adds a great deal of diversification to a cap-weighted portfolio, this is a significant drawback. But let's focus on the question only for cap-weighted equities: are call options or LETFs a better way to increase compensated risk?
Investors in LETFs need to understand that these funds are not magical machines that automatically multiply the daily returns of an index. The leverage depends on derivatives like total return swaps that are facilitated by banks who partner with the ETF issuers. The banks that administer total return swaps can set the terms of the arrangement, including margin requirements. LETFs are most likely to be shut down due to financial stress at exactly the wrong time, when the market is dropping and leveraged funds are suffering apocalyptic drawdowns. This would leave investors with whatever fraction of their money is left, without the ability to potentially make up their losses with the same leveraged fund. So following this advice is a good idea: "avoid, at all costs, issuers with poor ratings and small market caps not backed by substantial parents with deep pockets."
The quoted warning is crucial to understand. First, an LETF’s issuer should have the ability to meet increased margin requirements (i.e., fork over cash) during market crashes. Given the current offerings, I would be reluctant to invest in highly leveraged ETFs sponsored by anyone other than ProShares or Direxion. Second, the fund should have large AUM. During the 2020 COVID crash, a number of LETFs were liquidated, including funds managed by ProShares and Direxion. They were unwilling to save some of their smaller funds that were insufficiently profitable (or perhaps not profitable at all). And the COVID crash was not nearly the worst case scenario for LETFs: it was brief and witnessed only a 35% drawdown for US stocks. Due to the recent inception of LETFs, they have yet to endure a long bear market where the stock market is cut in half, like those in 1973-74, 2000-02, and 2007-09. How many LETFs will be shut down during the next crisis?
With these criteria, the only LETFs whose durability I am fairly confident in are those with billions of AUM. Among the list of seven funds above, the only funds that qualify are S&P 500 2x and 3x funds: SSO, UPRO, and SPXL. During bear markets, nervous investors pull their money out of equity funds. So LETFs with even greater losses than the market will undoubtedly lose investors during a crash, but these three funds have AUM to spare.
If you accept what I've stated so far, this implies that building a diversified equity portfolio with LETFs is not possible (without accepting the liquidation risk of less mainstream funds). Options do not carry any similar risk: counterparty risk is borne by the Options Clearing Corporation, so your option contract is sound regardless of economic distress.
LETFs have a lower minimum cost of entry: the share price. Long-dated call options are expensive, and there is no way to buy less expensive contracts that control fewer than 100 shares. LETFs are also more liquid: you pay less in bid-ask spreads.
With options, it is easy to customize the risk you want to accept by selecting from many strike prices. A 40% ITM option provides moderate leverage and somewhat heightened risk. A 10% OTM option is very risky and provides a great deal of leverage. With LETFs, you can customize risk by pairing an unleveraged ETF with a leveraged ETF, achieving between 1x and 3x leverage (or in the case of developed ex-US markets, up to 2x). You could invest 85% of a US equity allocation in VOO or VTI and 15% in UPRO.
The returns of an LETF are path-dependent, while the intrinsic value of an option is not. That is, different degrees of volatility for the index an LETF is leveraging lead to different returns. For a given return of an index, higher volatility of the index produces lower LETF returns. Thus, the 2020 COVID crash was minimally damaging to LETFs, because the market fell and recovered in a relatively straight line.
You could combine the two approaches and buy call options on LETFs. But let's not get crazy.
Discuss Hedgefundie portfolio: roughly 50% UPRO + roughly 50% TMF.
Click here to return to the beginning — Cover page
All sections:
- Cover page
- Introduction to index funds
- Thinking about risk
- Tax-advantaged accounts
- Your psychology
- Investing for retirement
- Guidelines for personal finance
- Building a stock portfolio
- Fund proposals
- Advice
- Practical information for execution
- Taxes
- Vocabulary and further resources
- Advanced topics
Footnotes:
1 Beyond one day, the multiplier does not apply. Let's say QQQ increased by 2% on day 1 and 1.5% on day 2. TQQQ would increase by 6%, then by 4.5%. The cumulative increase for QQQ would be 1.02 × 1.015 = 1.0353, or 3.53%. We can't simply multiply by three: for TQQQ it would be 1.06 × 1.045 = 1.1077, or 10.77%.
We can do another calculation to exhibit how mere volatility reduces the returns of leveraged funds. Let's say QQQ increased by 3% on day 1 and fell back to its previous level on day 2. QQQ's cumulative return would be: 1.03 × (1/1.03) = 1. TQQQ's cumulative return would be: 1.09 × (.94/1.03) = .9948 (explained below). So while QQQ's return after two days is flat, TQQQ's return is -.52%. This is just an example which shows that the movements of a leveraged fund need not be directionally the same as that of its underlying index, even after only two days.
To calculate the return of a triple-leveraged fund on a single day given its index's return (R), compute 3×(R-1)+1. Take the 2% increase of QQQ in the first example, so R = 1.02. 3×(1.02-1)+1 simplifies to 1.06 or 6%. That's pretty simple. Now take day 2 of the second example, where QQQ returns to its original level after rising 3% the prior day. We know the multiplier for QQQ must be 1/1.03 on day 2. So we insert that as R: 3×((1/1.03)-1)+1 simplifies to (.94/1.03), which is why I used that expression in the paragraph above. ↩
2 Had an investor done the same, but sold on Sep 29 2022, the value would've fallen by 75.5%, making the total multiplier 44 instead of 179. This is still incredible, but it illustrates the extreme volatility of this fund. The total drawdown between Nov 19 2021 and Sep 29 2022 was 77.0%. ↩
3 The calculations were done assuming that TQQQ's total drag factor was a constant .999916 per day, which corresponds to about 2.1% annual drag. The drag factor includes the expense ratio as well as trading costs. This must be accounted for because, due to high trading costs, the returns of leveraged funds are notably lower than you would expect given their expense ratios. A more accurate model would assume higher drag when interest rates are higher, which I will add at some point in the future. The returns for TQQQ after its inception in February 2010 are its actual returns; they are no longer inferred. ↩
4 Let's consider what the counterparty wants when they sell (AKA write) a covered call. An important feature of selling a covered call is that once the price is equal to or exceeds the strike price, the option writer is not affected by further increases in price. If the price increased to $60 by expiration, their profit would be dividends plus $241 ($741 premium + $1000 from holding 100 shares - $1500 from selling shares at the strike price). If the price fell to $45 by expiration, their profit would be dividends plus $241 ($741 premium - $500 from holding 100 shares). In this case they don't have to sell shares to the option holder because the option expired exactly ATM with no value. However, if the price fell below the strike price of $45, the option writer's profit would diminish below dividends plus $241 and would eventually become negative.
What's the significance of the breakeven price for the option writer? Assuming they hold 100 shares, the breakeven price of $52.41 is the point above which they would've profited more by not selling the call. They may not directly lose money if the price jumps to $60, but they'll wish they hadn't surrendered the upside to the option holder by selling the call. Due to the bid-ask spread, the exact breakeven price for the option holder is not a significant price for the option writer. When the option holder paid a $7.41 premium per share, the option writer might have received $7.10 per share. Any price at expiration above $45 + $7.10 = $52.10 would make the option writer wish they hadn't sold the call. Prices below $45 would make the covered call less profitable or unprofitable. Any difference in price at expiration between $45 and $52.10 is irrelevant to the option writer, whose profit will be $241 plus dividends in this range.
A call option writer is not forced to sell their 100 shares to the option holder. Like the option holder, they can exit the contract. An option holder enters the contract by selecting "buy to open" and exits by selecting "sell to close". An option writer enters by selecting "sell to open" and exits by selecting "buy to close". The writer would have to pay the contemporaneous option premium in order to buy out of the contract.
According to IRS publication 550, dividends received by someone who is "grantor (writer) of an option to buy substantially identical stock or securities" cannot be qualified dividends. So if the option writer were selling the covered call in a taxable account, they would unfortunately pay ordinary income tax rates on XY's dividends, purely because they sold a covered call. ↩