In this article, I will show you a way to use leverage to generate extra return, or alpha, to beat the market and make extra money. The key of this method are two fold. First, the leverage is adjusted dynamically. That is, we will apply different levels of leverage under different market conditions to maximize our return. The second key is that the method will help us to stay disciplined. Discipline is absolutely crucial for the use of leverage in the long run. As a result, the method will help us generate consistent extra return on our money.
The dynamic adjustment is based on volatility, which is relatively easier to predict than stock market returns. We will use the so-call VIX index, to measure the volatility of the market.
And the idea is to leverage less when VIX increases. And vice versa, to leverage more when the VIX decreases. As you can see from the blue curve.
In my portfolio, I just set the level of leverage to be inversely proportional to the index. In practice, I also cap my maximum leverage at 25% as shown by the green line. Of course, you can set a different maximum level that suite your own risk tolerance level. The point is that you have to set a limit and you stay disciplined within that limit. As already mentioned, discipline is absolutely crucial for the use of leverage in the long run.
This idea of using more leverage when volatility is low has been thoroughly discussed.
For example, you can see this following article. The title of the article is Alpha Generation and Risk Smoothing using Managed Volatility. And the authors is Tony Cooper. You can see discussions of the specifics of this idea and we won’t further elaborated them here. Here, let’s just directly the results and how this idea actually work.
This chart shows the performance of our leveraged model portfolio over 15 years or so. The performance of the aggressive portfolio is shown by the blue line since 2006. And the performance of the overall market, the S and P 500 index, is shown by the red line. As seen, the performance is compared during a 15-year period, from 2006 to 2020 . And the leveraged portfolio outperformed the S and P 500 index most of the time. It really took off and began to dominate the S and P 500 index shortly after the 2008 great crash was over. In terms of dollar amounts, the aggressive portfolio outperformed the overall market almost by more than 200% in the past 15 years.
For readers interested in more details, the following YouTube video provides more data and specifics:
https://www.youtube.com/watch?v=CJeppJCkBEs&t=11s
