After chatting with someone recently about the Hedgefundie adventure and rising interest rate environments, I decided to play around with applying leverage to the Ray Dalio All Weather Portfolio. Here we’ll look at the All Weather Portfolio’s components, historical performance, and various leveraged strategies.
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What is the All Weather Portfolio and Who is Ray Dalio?
First, we’ll take a brief look at what this portfolio is comprised of, and why. The All Weather Portfolio is an available-to-the-masses portfolio modeled somewhat after the risk-parity-based All Weather Fund from the famous hedge fund Bridgewater Associates. The portfolio idea was created by the legendary Ray Dalio, founder of Bridgewater, and was then popularized by Tony Robbins. Dalio has become almost like a god in the world of finance and investing, and rightfully so. I would highly recommend his bestselling book Principles, as well as his more recent book Big Debt Crises.
Note that the All Weather Portfolio as it is prescribed is not based on true risk parity. It is simply the product of an interview between Tony Robbins and Ray Dalio in which Dalio suggested that these weightings, without leverage, would be suitable and easy to manage for the average investor. Dalio even suggested that these weightings “would not be exact or perfect.” I explore options for true risk parity below later on in this post.
As the name suggests, the All Weather Portfolio is designed to be able to “weather” any storm. It uses asset class diversification based on seasonality in the interest of limiting volatility and drawdowns. The holdings and the allocations thereof correspond to Dalio’s view on economic “seasons.” Dalio’s strategy and expertise are so pervasive that the phrase “all weather” is now used to describe other portfolios that behave like his in surviving any economic climate, e.g. “investing in an all weather portfolio.”
Dalio proposes that the following four things affect asset value:
- Rising economic growth.
- Declining economic growth.
Based on these, Dalio expects we can see 4 “seasons” of the economy:
- Higher than expected inflation.
- Lower than expected inflation.
- Higher than expected economic growth.
- Lower than expected economic growth.
Dalio chose asset classes that performed well in each of these different seasons, with the goal being diversification that allows for consistent growth and small drawdowns. To minimize volatility, the portfolio is mostly bonds, and only allocates 30% to stocks.
The All Weather Portfolio looks like this:
- 30% US stocks
- 40% long-term treasuries
- 15% intermediate-term treasuries
- 7.5% commodities, diversified
- 7.5% gold
How to Build the Ray Dalio All Weather Portfolio
M1 Finance would be a good choice to implement the All Weather Portfolio so that you can easily and seamlessly rebalance as often as you’d like, and it has zero transaction fees. I wrote a comprehensive review of M1 Finance here.
Using mostly low-cost Vanguard funds, here’s the pie, which looks like this:
- 30% VTI
- 40% VGLT
- 15% VGIT
- 8% IAU
- 7% PDBC
To add this pie to your portfolio, just click this link and then click “Invest in this pie.”
To diversify internationally with the All Weather Portfolio above, simply replace VTI (Vanguard’s total US stock market ETF) with VT (Vanguard’s total world stock market ETF). That pie can be found here.
All Weather Portfolio Performance vs. S&P 500
Going back to 2006, here’s the All Weather Portfolio vs. the S&P 500 through 2019:
As we’d expect, the All Weather Portfolio has had half the volatility and, consequently, a much higher risk-adjusted return (Sharpe) and much smaller drawdowns.
I decided to also show this comparison through the end of March 2020 to show the recent stock crash and the All Weather Portfolio’s behavior, doing precisely what it’s intended to do – weather any storm:
Personally, I wouldn’t adopt the All Weather Portfolio unless I were near or at retirement age, or if for some reason I absolutely couldn’t mentally and emotionally endure volatility and drawdowns (which is a very real case for some). The gold, commodities, and heavy bond allocation would likely just drag down long-term total return since it’s only got 30% allocated to stocks.
I’m also usually not even a fan of gold or commodities period; they have no place in my portfolio at this time. That said, this would be a good set-and-forget portfolio, making it attractive for investors who want to be hands-off, and it is probably my favorite of the volatility-minimizing, any-economic-climate portfolios like the Permanent Portfolio, Golden Butterfly, and Ivy Portfolio.
However, levering up these same allocations may dramatically improve returns while still maintaining a sensible level of portfolio risk.
Applying Leverage to the All Weather Portfolio
Applying leverage to those same allocations gets you enhanced exposure to what is traditionally a low-risk, low-volatility portfolio. Most people don’t realize that Dalio and Bridgewater themselves deploy leverage in their in-house All Weather Fund. So perhaps this could be a solution for a risk-averse investor who still wants to get in on the leverage game in an attempt at higher returns to beat the market.
Some obligatory preliminary warnings:
- I’m not a financial advisor and this is not financial advice. It’s for informational and recreational purposes only.
- Past results do not indicate future performance.
- Research and read up on the fundamentals of leverage and the nature of leveraged ETF products before blindly buying in. It can potentially be a very dangerous game. That said, it’s not as much of an issue as it’s made out to be; more on this below.
- Similarly, don’t put your entire portfolio in a strategy like this. If you want to play with something like this, do so with a small piece of your total portfolio, and definitely not with money you’ll need in the next 5-10 years. If you’re using M1 Finance, make this a sub-pie within your larger pie.
- I had a hard time finding leveraged commodity index ETF’s (probably for good reason) so I somewhat arbitrarily chose a couple oil-and-gas ones I found. There may be better options. This is more just meant to be a discussion starter and a first iteration from which to improve. I discuss improvements using the Utilities sector below.
- Moreover, I realize this may not be the optimal approach for what it’s trying to achieve. Again, I’m not a fan of gold and commodities; I think I’ve fared better playing around with tilting with utilities and consumer staples in my cauldron of leverage: UPRO, TQQQ, TMF, UTSL, and NEED. This is simply taking the unedited All Weather Portfolio and applying leverage to it. More on this later, with options for using Utilities in place of Commodities.
- Of course, I also realize that applying leverage to the All Weather Portfolio sort of defeats its whole purpose, but the historical volatility, return, and drawdown KPI’s compared to the S&P 500 index and a 60/40 portfolio were much more impressive than I anticipated. More on that later. I’m viewing it as a way to diversify and limit volatility and drawdowns with the underlying assumption that one has already chosen to invest with leveraged products.
- The linked backtests using Commodities only go back to 2006. We get to see performance through the GFC, but not during a hyperinflationary period like the late 1970’s in the US. The All Weather Portfolio’s large allocation to long-term treasury bonds still expose it to interest rate risk.
- The fees alone for the gold and commodities may be a major drag on the strategies’ performance, with the trade-off being the extra diversification and subsequent drawdown protection and volatility reduction. They are probably not responsible for any of the actual returns of the strategies. Is it worth it? I don’t know.
- This would require some regular maintenance in the form of rebalancing, as the allocations may stray quickly. Quarterly should be fine. I explore different rebalancing intervals at the end of this post.
- M1 Finance doesn’t allow a 7.5% holding so I used 8% gold and 7% commodities.
Aren’t Leveraged ETF’s Unsuitable for Holding Long-Term?
There’s no shortage of articles lambasting the idea of holding leveraged ETF’s for more than one day, reciting that they should “only be used for intraday trading.”
However, I firmly maintain that the idea that leveraged ETF’s are unsuitable for long-term holding is largely overblown fear mongering that’s been wrongly perpetuated after the financial blogosphere took the scary-sounding “volatility decay” and ran with it.
“Volatility decay” sounds like a bad thing, but viewing it as such is simply a misunderstanding of what it actually is and its underlying mechanics and arithmetic. If you’re curious to see the math, check out this page.
That same “decay” actually works in your favor when the market goes up with decent momentum, which it does more often than it goes down. This is why UPRO, the 3x leveraged S&P ETF, has delivered close to 5x the returns of the SPX since its inception instead of the proposed 3x.
In short, I concede that leverage can indeed be dangerous in certain situations, but can be useful in others.
2x Leveraged All Weather Portfolio
So here’s the portfolio using 2x leverage:
- 30% SSO – 2x S&P 500
- 40% UBT – 2x LT treasury
- 15% UST – 2x IT treasury
- 7.5% DIG – 2x oil and gas
- 7.5% UGL – 2x gold
3x Leveraged All Weather Portfolio
And here’s that portfolio with 3x leverage:
- 30% UPRO – 3x S&P 500
- 40% TMF – 3x LT treasury
- 15% TYD – 3x IT treasury
7.5% GUSH – 3x oil and gas
- 7.5% UGLD – 3x gold
Update April 2020: After Direxion’s changing GUSH from 3x to 2x effective March 31, 2020, I would consider using 3x Utilities, REITs, or Consumer Staples, accessed via UTSL, DRN, and NEED respectively. Unfortunately, at the time of writing, M1 Finance doesn’t offer the NEED (3x Consumer Staples) ETF. Below I explain why Utilities are probably the best choice, and I’ve included a pie link for that option.
Here’s a backtest going back to 2006 comparing the above 2 with the Hedgefundie 55/45 strategy and the S&P 500 index:
Note the highest Sharpe ratio (risk-adjusted return), albeit only slightly, for the All Weather 2x above, with volatility almost identical to the S&P 500 but with much better Worst Year and Max Drawdown (from the GFC) stats.
Here’s a backtest going back to 2006 comparing the 2x All Weather above to the unleveraged All Weather Portfolio, a traditional 60/40 stocks/bonds portfolio, and the S&P 500 index:
The 60/40 achieves the highest Sharpe but with much lower return than and a nearly identical Worst Year and Max Drawdown to the 2x All Weather.
Update April 2020: After Direxion’s changing GUSH from 3x to 2x effective March 31, 2020, I would consider using 3x Utilities, REITs, or Consumer Staples, accessed via UTSL, DRN, and NEED respectively. Unfortunately, at the time of writing, M1 Finance doesn’t offer the NEED (3x Consumer Staples) ETF. Below I explain why Utilities are probably the best choice.
Using Utilities Instead of Commodities (and REITs)
I never felt comfortable anyway with using the leveraged oil/gas ETF’s (DIG and GUSH) as a proxy for the prescribed “broad commodities.” I now believe an objectively superior approach would be to use Utilities in its place, in any portfolio. Here’s why.
Commodities have been used in the past for their diversification benefit from their inherent low correlation to the total stock market, and the nature of the asset class being physical necessities on which futures are traded. The same can be said for real estate (REITs).
I don’t bet on sectors, but over the past 20 years, the Utilities sector has had the lowest correlation to the total stock market of any sector, lower than that of both Commodities and REITs – specifically, 0.38 for Utilities compared to 0.53 for Commodities and 0.59 for REITs. Yet REITs and Commodities are both treated as classes of their own and are used as diversifiers, while Utilities are simply thrown under the equities umbrella at their market weight and forgotten.
Andrew Tobias, in The Only Investment Guide You’ll Ever Need, maintains that “it is a fact that 90% of all people who play the commodities game get burned. I submit that you have now read all you ever need to read about commodities.”
Using data for Commodities going back to 2006, through 2019, the results corroborate this idea. I backtested portfolios using 90% total stock market with respective 10% tilts using Utilities, Commodities, and REITs. Utilities provided the lowest volatility, highest return, and highest risk-adjusted return (Sharpe):
Some other macroeconomic things to consider are:
- We’ll always need energy of some form, whether that’s solar, wind, natural gas, etc.
- Utility operating costs are passed on to the ratepayer.
- Perhaps most importantly, using Utilities instead of REITs lets you avoid the idiosyncratic, uncompensated risk of the real estate market.
- Of all sectors, Utilities are the least explained by the known equity factors that explain the differences in returns between diversified portfolios. Their R-squared ratio is notably lower than that of REITs. From this paper:
So, at least for the relatively small 7.5% slice for the All Weather Portfolio, I would submit that Utilities are a fine – and likely superior – replacement for Commodities.
For those wanting the unleveraged All Weather Portfolio using Utilities instead of Commodities, I’ve created that pie here. It looks like:
- 30% VTI
- 40% VGLT
- 15% VGIT
- 8% VPU
- 7% IAU
3x Leveraged All Weather Portfolio Using Utilities
Here’s a pie using UTSL (3x Utilities) in place of broad commodities. Interestingly, this may actually be a better choice anyway considering the backtest below.
- 30% UPRO – 3x S&P 500
- 40% TMF – 3x LT treasury
- 15% TYD – 3x IT treasury
- 7.5% UTSL – 3x utilities
- 7.5% UGLD – 3x gold
The backtest below compares the 3x AW with Utilities (directly above), the “traditional” 3x AW with commodities, 60/40, and S&P 500. The one using utilities does considerably better than the regular one with commodities.
The Sharpe ratio comes in only slightly below the 60/40, with a much higher CAGR.
True Risk Parity
Remember, the original All Weather Portfolio, while well-diversified, is not really based on risk parity, in which each asset is contributing in the same way to the portfolio’s overall volatility. Consistent with modern portfolio theory, we’re interested in how these assets contribute to the performance of the portfolio as a whole, not individually in isolation.
A superior approach for employing leverage in this context is probably to use true risk parity weightings. For those wanting a true risk parity portfolio using the above assets, using returns going back to 2002, it would be achieved with this pie at the following allocations:
- VGLT – 15%
- VTI – 20%
- VGIT – 40%
- VPU – 13%
- IAU – 12%
We’re essentially swapping the allocations of long treasuries and intermediate treasuries.
The 3x leveraged version would be this pie that looks like this:
- TMF – 15%
- UPRO – 20%
- TYD – 40%
- UTSL – 13%
- UGLD – 12%
Compared to the first “regular” 3x version above, going back to 1999, the risk parity version of 3x achieves a higher Sharpe (backtest results illustrated below) as we’d expect – lower return but much lower volatility and smaller max drawdown. Same goes for the unleveraged comparison.
I think I like the risk parity version more, because it’s had lower volatility, smaller drawdowns, and a higher Sharpe (the whole point of the All Weather) historically, and because I like intermediate treasuries in a bond-heavy portfolio. This version should maintain the original goals of the unleveraged All Weather Portfolio while significantly enhancing returns, provided you can stomach the volatility and drawdowns that accompany the use of leverage.
Optimal Rebalance Interval
Regular rebalancing is necessary with any of these leveraged portfolios, as the leveraged funds will likely quickly stray from their target allocations. Below I’ve compared the historical metrics from different rebalance intervals (annually, semi-annually, quarterly, and monthly) for the 3x version using risk parity and Utilities:
|Interval||CAGR||St. Dev.||Max Drawdown||Sharpe|
As I suspected, quarterly rebalancing performed the best historically, and would probably be the best choice going forward.
Were I to implement any of these, I’d probably go with the last one – 3x using risk parity and Utilities – and rebalance quarterly, using M1 Finance. That doesn’t mean you should blindly copy it. I’m relatively young with a long investing horizon and a high risk tolerance. As I said earlier, assess your own personal factors before diving into leveraged funds. The assumption of more risk gives you the potential for more reward, but also the potential for greater losses.
Hopefully it goes without saying that all of the above options aren’t ideal for a taxable account due to regular rebalancing.
Which one would you choose? Does the recent market turmoil have you reevaluating your true risk tolerance and considering an “all-weather” approach? Let me know what you think in the comments.
Disclosures: I am long TMF, UPRO, UTSL, and VTI.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information contained in the investing-themed posts on this website is for informational and recreational purposes only. Read my lengthier disclaimer here.