Concepts
Leveraged Indexing is the art and science of using borrowed capital to increase investment returns using passive indexed investing techniques. It is sometimes called "juiced indexing" or "indexing on steroids"
Indexing
The objective of indexing is to create an investment that matches the returns of a specific asset class through broad diversification. Originally, "the index" was assumed to be the S&P 500, but many new products have been introduced that allow investors to select a variety of styles, sectors, countries, etc.
Leveraged Indexing
Historically the total stock market index has returned approximately 10% annually with a 15% standard deviation. If money can be borrowed at a lower rate then and reinvested at this higher rate, a source of both return and risk is created. Margin debt typically has a high interest rate and low maximum leverage ratio, so the best tools to use are typically futures and options. The assets in the leveraged portfolio will, on average, compound faster than debt, but in some circumstances will negatively compound, eroding the base, therefore the index exposure and leverage ratio needs to be carefully managed.
Rebalancing
To rebalance a leverage portfolio, rebalance the assets across the portfolio. Rebalancing has a neutral effect on returns over time but reduces volatility, allowing either risk to be reduced or more leverage taken on. Maintaining equal weighting across a broad of indexes generally results in the lowest volatility, and is still effective even when correlations are relatively high.
Reinvestment
Reinvesting gains is the most challenging part of managing an investment portfolio. One strategy that reduces volatility is to maintain index exposure at a constant level and then grow it slowly over time. Alternatively, a constant fraction of assets can be cycled into short and medium-term investments to create an exponential "Kelley"-style curve. A poor strategy is that of the ProShares Ultra ETF, which attempts to maintain a constant leverage ratio over time and as a result can drastically change its level of index exposure over the course of a few months, creating tremendous volatility and over time, underperformance. (See the Leveraged ETFs section.)
Hedging
Unhedged leveraged positions are vulnerable to catastrophic meltdowns. Diversification provides some protection, but can not be solely relied upon as correlations and volatility can change suddenly. Hedging can be implemented through either call or put options, depending upon the strategy, and the most cost-effective positions involve both buying and selling hedges at the same time in order to secure only the necessary amount of protection.