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You can view the real-time holdings and performance of this strategy at http://stockalicious.com/stock_journal/553

Investment Strategy:

The portfolio strategy was developed around the use of the new leveraged ETFs (Exchange Traded Funds) that seek to double the daily performance of a particular index. The idea was first presented in the blog post entitled “Utilizing Leveraged ETFs to Simulate the Performance of the S&P with Less Risk“. The strategy is to create a diversified portfolio, which will lower the risk of the portfolio as a whole, all while maintaining the profitability of investing in an index. The goal of this portfolio is to allow a long-term investor to create a basket of securities that do not limit the upside potential of being invested in equities, while creating a cushion if the equity markets become negative. The main focus of the portfolio is for capital preservation, which is accomplished by investing in two asset classes that typically move inversely depending on the market conditions. Ideally, the portfolio would be rebalanced yearly to preserve the initial allocations. The yearly rebalancing will take profits on a security that has increased in value and add to positions in a security that have decreased in value over the year.

The initial allocations of the portfolio are as such:

The allocations by asset class are as follows:

Since the portfolio was started on June 21, 2006, and the investment strategy calls for a yearly rebalancing, I decided to rebalanced the portfolio on January 2, 2007 to the following allocations:

There were sells Proshares 2x Leveraged S&P 500 ETF and the iShares EAFE Value Index ETF. I added to all of the fixed income positions to bring them back into line with the suggested allocations.

Below are the current positions and their values as of April 20, 2007:

By clicking on the picture below you can view the entire transaction history.

Past Performance:

The performance, since June 21, 2006, has been positive, and it has beaten its benchmark of the S&P 500. The portfolio as of Thursday, April 19, 2007, has a return of 23.41% (including dividend reinvestments), while the S&P 500 has returned 17.45%. The portfolio outperformed the benchmark by 5.96%, all while diversifying the portfolio with fixed income and international equity allocations. While this past performance is only taking into account a short testing period, by following the investment strategy, the portfolio should continue to exceed the index benchmark.

Description of Portfolio Holdings:

SSO – Proshares Ultra S&P 500 ETF – This is the core holding in the portfolio; it gives an investor the ability to invest in a basket of 500 stocks and leverage those at 2 times via the use of options, swaps, and other derivatives utilized by the management company. The expense ratio on this ETF is .95%, which is a bit on the high end for an ETF, but when the investor takes into account the benefit of leverage, the expense ratio comes to about .425%, which is comparable to similar index funds. The competition portfolio had an initial ratio of $50,000 invested in this fund, which represents 50% of the initial capital, and a pseudo-position of $100,000 since the ETF is 2 times leveraged.

AGG – iShares Aggregate Bond Index ETF – The second largest holding the portfolio, this ETF is the core fixed income asset. It is also not a leveraged product, but it gives the investor the exposure to the less volatile fixed income market. The idea in utilizing this security is to hold an asset that has a low correlated, inverse relationship to the equity markets. The ETF is diversified among 143 securities, currently yields 4.63%, and has an expense ratio of .20%. The initial allocation to this ETF was 25% of the portfolio, or $25,000.

EFV – iShares EAFE Value Index ETF – This is the other equity holding in the portfolio. This ETF gives the investor a one to one exposure to the strong international markets. This ETF is also a play against the continued depreciation of the US Dollar against all the major world currencies. It is diversified among 531 companies located in the mature European, Australasia (Australia and Asia), and the Far East markets. The expense ratio for this ETF is .40%. The portfolio’s initial allocation to the EAFE Value Index ETF was $15,000 or 15% of the portfolio.

TIP – iShares Treasury Inflation Protected Securities ETF – The key idea behind using this ETF is to protect against inflation, which is a potential problem should energy prices continue to rise and the US Dollar continues to fall causing foreigners begin to stop financing the US Government debt. The fund currently yields 4.35% and has an expense ratio of .20%. The fund is only invested in US Government bonds making this fund fairly risk free. The initial allocation to this ETF was $5,000, or 5%.

LQD – iShares iBoxx Investment Grade Corporate Bond ETF – The utilization of this ETF is to diversify the bond holdings to the higher yielding corporate bonds markets. The fund only invests in Investment Grade bonds; therefore, the risk is relatively low. This fund would have a higher correlation to the equity markets than the Aggregate Bond Index, which holds more government securities. The fund is diversified among 100 different securities, currently yields 5.65% and has an expense ratio of .15%. The initial allocation to this ETF was 5%, or $5,000.

Long-Term Leveraged ETF Performance:

One of the risks in investing in Leveraged ETF products is that they are rebalancing the composition daily because they are used to double the daily performance of the market. Therefore, in the extreme example, if the market fell 10% today and rose 10% tomorrow, on an actual index the loss would be 1%, while a leveraged ETF would have lost 20% today and gained 20% tomorrow, giving a total loss of 4%. In that instance, the compounding effect could have a substantial negative effect on the portfolio performance.

However, before choosing this strategy, I ran a test going back to 1998 when the first 2 times leveraged fund was introduced as a mutual fund. This fund was the ProFunds UltraOTC Mutual Fund (UOPIX), which doubled the daily performance of the NASDAQ 100. A simulation ran with an initial $100,000 investment, half committed to the Ultra Fund and the other $50,000 committed to the Vanguard Total Bond Market Fund (VBMFX). The portfolio was rebalanced on a yearly basis, by keeping the 50/50 allocation. While an initial investment in the NASDAQ 100 back in 1998 at the start of this simulation would be worth, total, about $150,000, or a 50% return, the test portfolio that was rebalanced yearly between the UOPIX NASDAQ Fund and VBMFX is worth $283,092 today, yielding a 183% return. The reason for the substantial outperformance was that when the NASDAQ continued to climb during the technology bubble, people were taking profits out of the leveraged position (selling shares) and placing those gains into the bond fund. Then during the tech bubble crash and subsequent recession, profits were taken from the bond fund, which increased tremendously during that time, and reinvested into the 2x NASDAQ 100 fund to maintain the 50-50 allocation. When the NASDAQ finally began to recover, we were able to receive those benefits from the constant rebalancing. As one can see, the rebalancing creates an effect that takes profits as the market climbs while adding to positions as the market falls. The fact that this portfolio withstood a huge fall in the NASDAQ following the bubble years shows the true long-term stability of this approach.

I could not obtain a graph going back to 1998, but the graph below goes back to April 6, 2002. As shown, the Leveraged Portfolio has performed almost in line with the Nasdaq 100. The strategy will underperform the market during bullish times, as seen currently in the market, but in a downturn, the fixed income aspect will play a bigger role in capital preservation.

Conclusion:

This portfolio strategy is very low maintenance and does not require individual security analysis. To the typical investor, the individual company analysis is very stressful and can take a lot of time to develop. Thus, this strategy allows the investor to create a portfolio that systematically promotes smart money management techniques and takes out the time commitments that come with building a truly successful portfolio. The strategy behind this portfolio allows the investor to set it and forget it for a year. Though I would not see the NASDAQ 100 as a good long-term index, the investment portfolio developed for this competition follows the S&P 500, and can give a long-term investor the ability to take out the stress of investing. The original goal for this competition tasked us to develop a strategy that would allow someone to save for retirement and for his/her children’s college tuition. Therefore, I would say that a somewhat conservative approach that allows an investor to use hedge fund tactics meets those criteria. For that type of investor, something with diversification is ideal. I fully believe that this portfolio meets the goals of this investor or any investor who seeks good long-term returns with minimal thought, effort, and risk.