The Bogleheads forum is typically a haven for conservative investment strategies, so you might be surprised to discover that it’s the birthplace of a rather unconventional investment approach: the "Hedgefundie" strategy, which embraces the use of 3x leveraged ETFs.

This bold strategy emerged from a forum user named "Hedgefundie" who proposed a daring portfolio leveraging both the stock market and long-term treasuries.

The crux of the strategy involves combining ProShares UltraPro S&P500 (UPRO), a 3x leveraged ETF that aims to triple the daily performance of the S&P 500, with Direxion Daily 20+ Year Treasury Bull 3X Shares (TMF), which seeks to triple the daily movement of long-term U.S. Treasury bonds.

Hedgefundie recommended a 55/45 allocation between UPRO and TMF, respectively, effectively creating a 165/135 allocation between S&P 500 stocks and long-term treasury bonds.

Curious about the outcome of such a high-stakes strategy? Stay tuned to find out how this audacious portfolio has performed.

What is UPRO?

UPRO is a leveraged ETF from ProShares designed to return 3x the daily returns of the S&P 500 index. The key term here is "daily," which introduces a significant element known as sequence of returns risk.

This risk arises because the ETF aims to triple the daily movements of the S&P 500, and over time, volatility can erode the value of the investment, a phenomenon often referred to as "volatility drag." UPRO's prospectus highlights this, stating:

"Your return will tend to be better than the Daily Target when there are larger Index gains or losses and lower Index volatility. You may lose money when the Index return is flat (i.e., close to zero) and you may lose money when the Index rises."

The ETF's prospectus even provides a handy table showing the range of investment outcomes subject to index movements and volatility.

Contrary to what many investors might assume, UPRO could indeed be wiped out. While market circuit breakers exist, they haven’t been tested for these types of products, and ProShares can liquidate UPRO if it nears a 100% loss.

"If the Index [S&P 500] approaches a 33% loss at any point in the day, you could lose your entire investment."

Furthermore, UPRO involves counterparty risk due to its reliance on swaps to achieve its 3x leverage. Again, the prospectus notes:

"... if the Index has a dramatic intraday move that causes a material decline in the Fund’s net assets, the terms of a swap agreement between the Fund and its counterparty may permit the counterparty to immediately close out the transaction with the Fund. In that event, the Fund may be unable to enter into another swap agreement or invest in other derivatives to achieve its investment objective."

Given these considerations, I view UPRO as, at best, an inefficient method of leveraging the S&P 500 and, at worst, reckless.

Since its inception in 2009, UPRO has delivered a Compound Annual Growth Rate (CAGR) of 32.52%, compared to the S&P 500 ETF (SPY) at 14.79% — not quite the 3x novice investors suspect, and with a standard deviation three times higher than that of SPY (51.45% vs. 17.11%).

Additionally, it's costly, carrying a 0.92% expense ratio. Personally, if I were looking to leverage, I'd opt for using margin or futures as more direct and potentially less costly alternatives.

What is TMF?

TMF seeks to deliver a daily return that is three times that of the ICE U.S. Treasury 20+ Year Bond Index. Like UPRO, TMF is subject to the typical risks associated with 3x leveraged ETFs, but it faces additional challenges due to its focus on long-term treasury bonds.

As a treasury ETF, TMF inherently carries interest rate risk rather than market risk. Essentially, when interest rates rise, bond prices fall, and vice versa. This inverse relationship is dictated by the concept of duration, which measures a bond's sensitivity to changes in interest rates. The longer the duration, the more sensitive the bond is to shifts in rates.

For context, the non-leveraged counterpart of TMF, the iShares 20+ Year Treasury Bond ETF (TLT), currently has an effective duration of 16.76 years. This high duration implies that even small movements in interest rates can significantly impact TLT's price.

When you consider TMF’s aim to triple these movements, the potential for dramatic swings becomes evident, making its strategy appear particularly aggressive.

This high level of rate sensitivity played a significant role in TMF’s performance during periods of rising interest rates. Indeed, the ETF underwent a 1-for-10 reverse split in 2022 as it was heavily impacted by the increasing rate environment—a key factor in the struggles of the "Hedgefundie" portfolio, as we will soon see.

Moreover, with a volatility drag and a 1.04% expense ratio, it's not surprising that TMF has historically underperformed its non-leveraged counterpart TLT. Since inception, TMF has experienced a maximum drawdown of an incredible -92.04% and a standard deviation of 45.89%, three times that of TLT.

How did the Hedgefundie portfolio perform?

Academically, I understand the rationale behind Hedgefundie's strategy—it was an attempt to take a portfolio on the efficient frontier and amplify its potential with leverage.

The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk. Hedgefundie chose a 55/45 allocation of stocks and Treasuries, traditionally seen in balanced portfolios like 40/60, 50/50, or 60/40, and applied leverage to target his desired risk-return.

However, this strategy heavily depends on historical correlations holding firm—specifically, the expectation that Treasuries rally when stocks falter. The flaw became apparent in years like 2022, when the backdrop of rising rates amid high inflation eroded this correlation. Consequently, Treasuries fell alongside stocks, with longer-duration bonds suffering the most.

Despite this, the Hedgefundie portfolio has posted impressive numbers; even with the challenges of 2022, it achieved a Compound Annual Growth Rate (CAGR) of 24.63% compared to 14.79% for the S&P 500 (SPY) since May 2009. It also managed a similar risk-adjusted return, with a Sharpe ratio of 0.73 versus 0.74 for SPY.

However, the volatility of this strategy is not for the faint-hearted—an annualized standard deviation of 28.85% and a maximum drawdown of 70.58% are levels that most investors would find difficult to endure, potentially leading to capitulation under stress.

How could Hedgefundie's approach be improved? Incorporating a third, non-correlated asset might help stabilize the portfolio. Gold is a potential candidate, but more dynamic strategies like managed futures could also be beneficial.

Managed futures can help hedge against market volatility by taking long and short positions in various commodity and financial futures markets based on trend-following.

Then again, most investors would be better off steering clear of such high stakes leveraged strategies altogether. For the average investor, the potential for high returns may not justify the extreme risks and emotional rollercoaster of managing such a volatile investment approach.