Leveraged index funds (long term)

[boggler]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

[rmelvey]

You are aware that stocks are not safer the longer they are held right? Risks compound in the same fashion as do returns. Time horizon is not a magical free lunch that allows you to circumvent the risk/return relationship.

[boggler]

You are aware that stocks are not safer the longer they are held right? Risks compound in the same fashion as do returns.

Can you elaborate on this? This may very well be true, but I have not heard this before. I'm still learning.

[rmelvey]

You are aware that stocks are not safer the longer they are held right? Risks compound in the same fashion as do returns.

Can you elaborate on this? This may very well be true, but I have not heard this before. I'm still learning.

Well you can do some reading on it. Zvi Bodie or Paul Samuelson are decent places to start. You can also intuitively see it by looking at put option prices. Put options (insurance against stock losses) get more expensive the longer you go out. Time is a magnifying factor for both risk and return.

[cjking]

I've heard the argument that dispersion is always increasing with time a few times, and I'm not sure it is entirely true. There are no 30 or 40 year put-options with a market price attached. (I'm not looking to start an argument, the argument's been had on here, and the case is not provable in either direction.)

I agree it is true on a shorter timescale.

I'm not sure where I'd put the crossover point between true and not entirely true, but I'd guess at a timescale of 15-20 years.

Mathematically speaking, random walk models say dispersion always increases with time, but economically speaking, I really doubt that there are no constraints on where earnings and PE multiples can wander to.

To answer the OP's question, I think the only way for you to be sensibly leveraged is to prioritise building up your portfolio over paying down a mortgage. Any leverage held within securities you might invest in will either make no difference to your expected return (because the blow-ups will offset the increased returns to a degree that the market priced-in in advance) or, if using outside-the-market leverage to buy market-price securities, you worsen your risk-reward ratio, because the market doesn't know you are leveraged and won't compensate you for the additional risk that entails.

[Beat The Street]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

Yes PIMCO offers a few index funds similar to what you are seeking. Check out PCKPX. What they do is buy index linked derivatives and place the collateral in the total return fund. The alpha should equal the performance of the total return fund. The risk is the TR fund having a negative return so then you will lag the index (Russell 2000). The TR fund has been great the last 20 years but we all know past performance is no indicator. PCKPX is for small caps and they offer a few other funds for other indices. You should check them out at PIMCO's website.

[Beat The Street]

http://investments.pimco.com/Products/p ... Code=INSTL

[hicabob]

profunds has funds that let you leverage long, short, double, quadruple or pretty much whatever. Of course there is a cost to the leverage.
Not very bogleheady!
http://www.profunds.com/

[boggler]

To answer the OP's question, I think the only way for you to be sensibly leveraged is to prioritise building up your portfolio over paying down a mortgage.

This is interesting, and I've seen the suggestion to just take out a mortgage before. Why - is this the only way to gain true leverage that doesn't have the risk of getting wiped out due to margin call in a down market?

Any leverage held within securities you might invest in will either make no difference to your expected return (because the blow-ups will offset the increased returns to a degree that the market priced-in in advance) or, if using outside-the-market leverage to buy market-price securities, you worsen your risk-reward ratio, because the market doesn't know you are leveraged and won't compensate you for the additional risk that entails.

By outside-the-market leverage, do you mean buying on a margin loan instead of using derivatives or other financial products that are intrinsically leveraged? Can you elaborate a little more on this point? It sounds intriguing but I'm not sure what you're getting at.

[mhc]

I would be concerned about the expense ratios of leveraged funds. One of the few things you can control is costs.

[stlutz]

Interactive Brokers will extend you a margin loan at 1.66%. That's probably the cheapest way to leverage right now.

If you don't want get wiped out completely, your other option is options, but you of course have to pay option premiums for that downside protection. As a result, you end up with a lottery-like return distribution--i.e. you'll probably lose but you might win big.

[boggler]

Yes PIMCO offers a few index funds similar to what you are seeking. Check out PCKPX. What they do is buy index linked derivatives and place the collateral in the total return fund. The alpha should equal the performance of the total return fund. The risk is the TR fund having a negative return so then you will lag the index (Russell 2000). The TR fund has been great the last 20 years but we all know past performance is no indicator. PCKPX is for small caps and they offer a few other funds for other indices. You should check them out at PIMCO's website.

Their website (at least until you dig into the prospectus) seems to indicate that they're getting "free money" by simply buying index-linked derivatives and then investing the rest in bonds. Presumably this additional return is justified given the risk that market volatility could reduce returns, and that the bonds have risks as well?

Why don't more people buy these?

[boggler]

profunds has funds that let you leverage long, short, double, quadruple or pretty much whatever. Of course there is a cost to the leverage.
Not very bogleheady!
http://www.profunds.com/

The website for the UltraBull ProFund states:

The UltraBull ProFund seeks daily investment results, before fees and expenses, that are 2x the return of the S&P 500® (the "Index") for a single day.

Do there exist any funds that return a multiple of the return of the index that don't have the daily/monthly compounding issue? Since my time horizon is so long, I would love to be able to buy 2x the S&P, for example, and be able to leave it alone for decades.

[Chan_va]

If there was a magical strategy that could produce 2x the returns over the long term with no additional risk, then someone could create a long term fund that was 2x the leverage of the leveraged fund, so 4x with no additional volatility. Then 8x, 16x and on to infinity.

You will have better luck building a perpetual motion machine than breaking the risk reward relation.

That being said, if you do want to get 2x the returns of the S&P (at greater risk) over a period longer than 1 day, then an options play on a 2x leveraged ETF will get you what you want.

[MN Finance]

I'm an aggressive investor and have no problem with risk but the risk of losing more money than you put into the market is not a strategy that makes a lot of sense. 1 theres no efficient way to execute. 2 the market can stay irrational a lot longer than you can stay solvent 3 the trade off of being wrong is far greater than being right (so what if you end up with 500k more in 20yrs of the other side of the bet is going broke entirely). If you haven't you should read markettimers post from 2007

[Beat The Street]

Yes PIMCO offers a few index funds similar to what you are seeking. Check out PCKPX. What they do is buy index linked derivatives and place the collateral in the total return fund. The alpha should equal the performance of the total return fund. The risk is the TR fund having a negative return so then you will lag the index (Russell 2000). The TR fund has been great the last 20 years but we all know past performance is no indicator. PCKPX is for small caps and they offer a few other funds for other indices. You should check them out at PIMCO's website.

Their website (at least until you dig into the prospectus) seems to indicate that they're getting "free money" by simply buying index-linked derivatives and then investing the rest in bonds. Presumably this additional return is justified given the risk that market volatility could reduce returns, and that the bonds have risks as well?

Why don't more people buy these?

Most people do not buy what they don't understand. I think these are the closest solution to what you are trying to achieve.

[baw703916]

Do there exist any funds that return a multiple of the return of the index that don't have the daily/monthly compounding issue? Since my time horizon is so long, I would love to be able to buy 2x the S&P, for example, and be able to leave it alone for decades.

No, there aren't any funds that do this.

Ways that you can do this yourself include:

-options (specifically, deep-in-the-money call options on SPY). For these things, the term premium tends to mostly reflect the current interest rates, as effectively you are borrowing money, and institutional investors can arbitrage option prices against the underlying security and the risk-free rate. You can't usually get these for more than a couple years, long-duration options tend to be very illiquid, and you are only gettting the price appreciation of the index itself, not getting any dividends.

-Borrowing money yourself to invest. Actually buying on margin is a really bad idea, because you can become a forced seller if your broker decides your financial situation is too precarious. But if you borrow against your house (say you have plenty of equity and a stable job situation and are able to do a cash-out refinance at a lower interest rate, and will be able to meet the mortgage payments no matter what happens to the stock market)... The thing is, you really can't scale this for very long--the amount of money that it's reasonable to borrow depends on your cash flow, not on your portfolio value.

-Buying riskier equities. There's lots of debate about size and value premiums, but it seems like it should be possible to identify which classes of stocks are riskier. In the case of value stocks, many value companies tend to be rather leveraged themselves, so one explanation that has been given for the value premium is that the stockholders are in effect leveraging by owning them.

[boggler]

If there was a magical strategy that could produce 2x the returns over the long term with no additional risk, then someone could create a long term fund that was 2x the leverage of the leveraged fund, so 4x with no additional volatility. Then 8x, 16x and on to infinity.

To make sure I understand, are you saying that since you've only put up 1x funds to buy the securities, that your downside is limited to 1x while your upside is 2x, and therefore you're not truly taking any additional risk?

That being said, if you do want to get 2x the returns of the S&P (at greater risk) over a period longer than 1 day, then an options play on a 2x leveraged ETF will get you what you want.

Interesting. I'm trying to reconcile the two things you said above. Where is the risk in the options play on the 2x leveraged ETF? In other words, how is this possible considering what you said above?

[boggler]

Do there exist any funds that return a multiple of the return of the index that don't have the daily/monthly compounding issue? Since my time horizon is so long, I would love to be able to buy 2x the S&P, for example, and be able to leave it alone for decades.

No, there aren't any funds that do this.

Ways that you can do this yourself include:

-options (specifically, deep-in-the-money call options on SPY). For these things, the term premium tends to mostly reflect the current interest rates, as effectively you are borrowing money, and institutional investors can arbitrage option prices against the underlying security and the risk-free rate. You can't usually get these for more than a couple years, long-duration options tend to be very illiquid, and you are only gettting the price appreciation of the index itself, not getting any dividends.

...

Is this what the leveraged funds do? How come I can do this but there are no mutual funds to do it for me (all the ones that exist are short-term focused)?

[nisiprius]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

No, there are no such funds or ETFs because of the way they work. If you want the reward for taking risk, you must actually take that risk. The risks are large and Boglehead forum poster "market timer" did himself real harm, financial and psychological, when he tried to do it.

Don't even start to believe that some mutual fund or ETF will take all that risk themselves and just give you only the reward. Not even the Tooth Fairy will do this.

Think about it. The only way there could be such a fund would be if there were a way for a mutual fund or ETF to have a negative value per share.

I'm not suggesting this, but if you want more reward and more risk than 100% Total Stock, you might consider the possibility of using using a small-cap value index fund. In theory that ought to give you what you want--more risk and more reward than the market--without leverage. And there's some kind of fairly long statistical data base of past behavior to help you judge how much risk there has actually been and how much reward there has actually been.

[Chan_va]

If there was a magical strategy that could produce 2x the returns over the long term with no additional risk, then someone could create a long term fund that was 2x the leverage of the leveraged fund, so 4x with no additional volatility. Then 8x, 16x and on to infinity.

To make sure I understand, are you saying that since you've only put up 1x funds to buy the securities, that your downside is limited to 1x while your upside is 2x, and therefore you're not truly taking any additional risk?

That being said, if you do want to get 2x the returns of the S&P (at greater risk) over a period longer than 1 day, then an options play on a 2x leveraged ETF will get you what you want.

Interesting. I'm trying to reconcile the two things you said above. Where is the risk in the options play on the 2x leveraged ETF? In other words, how is this possible considering what you said above?

I was typing an answer but nsprius beat me to it. They don't exist because you are asking for a free lunch. 2x the return for 1x the downside.

The reason that intra day 2x etf's exist is that they can get a short term loan. The loaner takes the short term risk that the s&p wont tank 50% in a day. No one will give your long term fund a loan to take a long term leveraged bet on your behalf.

[baw703916]

I can buy a SPY call option with maturity approximately one year from now (Jan. 18, 2014), with a strike price of $75. As of yesterday it had a bid of $76.49 and an ask of $77.10.

So isn't the person selling me the option lending me money for a year to double my exposure? Granted I lose the dividends, but it certainly is possible to make a longer term leveraged bet.

I think the reason that mutual funds only exist with daily coverage is that there are many more people out there withshort time horizons. (for the option example above the "open interest" only consists of 80 contracts).

Brad

[sometimesinvestor]

Because things reset every day pros who use leveraged etfs like those of Proshares generally hold them for a very short period of time.
Example you own a 2x s+p fund . Day 1 the market is up 2% and you make 4%. Investment of 100 now 104. Day 2 market is down 2% . your investment is now worth.96 X 104 =.9984 so instead of breaking even you are ina whole. Basically you only want to own this for a period of time in which the market is up almost every day(or down almost every day if you want an inverse fund.

[MN Finance]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

No, there are no such funds or ETFs because of the way they work. If you want the reward for taking risk, you must actually take that risk. The risks are large and Boglehead forum poster "market timer" did himself real harm, financial and psychological, when he tried to do it.

Don't even start to believe that some mutual fund or ETF will take all that risk themselves and just give you only the reward. Not even the Tooth Fairy will do this.

Think about it. The only way there could be such a fund would be if there were a way for a mutual fund or ETF to have a negative value per share.

I'm not suggesting this, but if you want more reward and more risk than 100% Total Stock, you might consider the possibility of using using a small-cap value index fund. In theory that ought to give you what you want--more risk and more reward than the market--without leverage. And there's some kind of fairly long statistical data base of past behavior to help you judge how much risk there has actually been and how much reward there has actually been.

Good summary. And good point about stock segmentation. If a fund did exist to increase risk/return it would generally be based on the S&P (though certainly there are 2X funds on the Russell 2000 et al). And if you apply leverage / options, you'd want to use something with as much volume / liquidity as possible so you're not stuck and that would probably leave to with a derivative of the S&P. However, the S&P is among the lowest risk market segments, so you can effectively increase risk is many other conventional ways. You can very easily load the portfolio with small, value, international, etc and have a higher expected return. I'm not 100% equities, but closer to 70%, however, my 70% is extremely heavy into small/value/international/EM. I have way more risk than someone 70% VTI. This is a far better idea (if taking more risk is the forgone conclusion). I opened an IRA for my 1 year old some time ago and put 10k in emerging markets. High risk/reward and 60 year time horizon and he doesn't know it even exists. There's no need to take more risk than that because that's plenty.

Very approximately, IFA data for 50 yrs gives the S&P a 10% RET 15% SD, EM (Small/Val) 18% RET 20% SD. You would have gotten 80% more than the market with 1/3 more risk. If your option was some 2X S&P product or options strategy, obviously something more conventional but factor loaded is more attractive.

[cjking]

To answer the OP's question, I think the only way for you to be sensibly leveraged is to prioritise building up your portfolio over paying down a mortgage.

This is interesting, and I've seen the suggestion to just take out a mortgage before. Why - is this the only way to gain true leverage that doesn't have the risk of getting wiped out due to margin call in a down market?

Yes, and even then I've seen some mortgage products with small print that would cause me to rule them out.

Any leverage held within securities you might invest in will either make no difference to your expected return (because the blow-ups will offset the increased returns to a degree that the market priced-in in advance) or, if using outside-the-market leverage to buy market-price securities, you worsen your risk-reward ratio, because the market doesn't know you are leveraged and won't compensate you for the additional risk that entails.

By outside-the-market leverage, do you mean buying on a margin loan instead of using derivatives or other financial products that are intrinsically leveraged? Can you elaborate a little more on this point? It sounds intriguing but I'm not sure what you're getting at.

Yes, that's what I meant, though I'm not completely sure I'm making sense. My previous post made sense to me at the time!

What I was trying to get at, is that if the borrowing is the other side of a market price from you, the market will take into account. The market should price all companies to have the same expected return. Leverage companies have an increased probability of going to infinity or zero, but the expected return (the weighted average of all possible outcomes) should be the same as the expected return on equities generally, I think.

On the other hand, if you can borrow money yourself without risk of the loan being pulled at the wrong time, then I think you can increase the expected return. A residential mortgage (where I am anyway) won't be pulled even if the collateral melts, as long as you keep up payments. But of course you could lose your job, so even that isn't really a safe form of borrowing.

That's about as close as I can get to making sense of whatever was going through my mind earlier.

[boggler]

I'm not suggesting this, but if you want more reward and more risk than 100% Total Stock, you might consider the possibility of using using a small-cap value index fund. In theory that ought to give you what you want--more risk and more reward than the market--without leverage. And there's some kind of fairly long statistical data base of past behavior to help you judge how much risk there has actually been and how much reward there has actually been.

This is interesting. I've often wondered how the risk-return options stack up. The traditional stuff I've heard generally says: Stocks > Bonds > Cash, in terms of both risk and return. What is greater than stocks in terms of higher return for higher risk? Venture capital/private equity would be one, right? Are there any that are actually liquid and tradable in a brokerage account, but still diversified?

[jasonv]

It seems to me that tilting towards small cap and value would be a lower cost way to push further out along the risk/return spectrum than using leverage.

[gtwhitegold]

As mentioned at before, the daily leveraged ETFs have a great amount of tracking error and do not include dividends. Some ETNs with monthly resets may have less tracking error and some pay out dividends, but all that I know about are for very specific area of the market such as mortgage REITs, MLPs, and BDCs, which you may not be interested in investing in in the first place. If you are interested in holding a long term investment in leveraged funds, I would not use derivatives, and I would limit the amount to something that you would consider play money, since that is just as likely to lose a great deal as gain a great deal of money. Also, note that ETNs are a debt instrument and if for some reason the issuing bank went belly up, you have the potential of losing your entire investment.

Allen

[ResNullius]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

Sounds like a good way to be broke for the rest of your life, but good luck nonetheless.

[baw703916]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

Sounds like a good way to be broke for the rest of your life, but good luck nonetheless.

I thought this thread had pretty much concluded that there are no such funds.

So he's not likely to go broke investing in them.

[Akiva]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

The ETFs all have daily recompounding and other issues that make them undesirable for holding long-term. If you want to take a long term leveraged position you should consider using futures on the index or buying deep in the money calls on an ETF that tracks the index. These should both be cheaper than buying on margin through IB unless your account is massive to begin with.

[boggler]

This article describes leveraged ETNs that actually are designed for long-term use. They don't suffer from the daily rebalancing problems, and thus your return after a year should be the leverage ratio times the return of the index.

http://www.investingdaily.com/11134/lev ... s-intended

But how is this possible? Posts above observed that taking 1x the downside risk for 2x the upside risk isn't really possible, yet these funds seem to do it. Can anyone explain this?

[Akiva]

This article describes leveraged ETNs that actually are designed for long-term use. They don't suffer from the daily rebalancing problems, and thus your return after a year should be the leverage ratio times the return of the index.

http://www.investingdaily.com/11134/lev ... s-intended

But how is this possible? Posts above observed that taking 1x the downside risk for 2x the upside risk isn't really possible, yet these funds seem to do it. Can anyone explain this?

These ETNs have issues of their own. If you want leverage, you should use futures or options like I suggested above.

[boggler]

This article describes leveraged ETNs that actually are designed for long-term use. They don't suffer from the daily rebalancing problems, and thus your return after a year should be the leverage ratio times the return of the index.

http://www.investingdaily.com/11134/lev ... s-intended

But how is this possible? Posts above observed that taking 1x the downside risk for 2x the upside risk isn't really possible, yet these funds seem to do it. Can anyone explain this?

These ETNs have issues of their own. If you want leverage, you should use futures or options like I suggested above.

Like what? I agree with you that they probably don't make sense, especially given the high fees, but I'm trying to understand the theory behind it: How can they offer 2x the upside risk and only 1x the downside? Do they liquidate if the market drops too far?

[cjking]

I've taken a quick look, just a few minutes late at night at the end of a long day, when my brain wasn't functioning to well, but those funds do seem to be exactly what you're looking for.

Haven't looked closely at the costs, but I think you do have the feature that your exposure will be liquidated at the worst possible moment, if there is a severe downturn. That is reason enough for me not be interested. There is the additional disadvantage of counter-party risk: if the issuer goes bust, you lose your money.

So compared to a simple index fund, higher charges and two whole extra categories of risk, over and above ordinary volatility, which is the only risk you are being paid to take.

[cjking]

Yes I think they do liquidate - haven't read the small print, just skimmed some of the simpler documents and got that impression.

[boggler]

I've taken a quick look, just a few minutes late at night at the end of a long day, when my brain wasn't functioning to well, but those funds do seem to be exactly what you're looking for.

Haven't looked closely at the costs, but I think you do have the feature that your exposure will be liquidated at the worst possible moment, if there is a severe downturn. That is reason enough for me not be interested. There is the additional disadvantage of counter-party risk: if the issuer goes bust, you lose your money.

So compared to a simple index fund, higher charges and two whole extra categories of risk, over and above ordinary volatility, which is the only risk you are being paid to take.

So it sounds like (to a first approximation) you are essentially hiring the issuer to invest in the index on a margin loan on your behalf (though at a better interest rate than you could get alone). If the index drops too far, they institute their own margin call and you are left with a liquidated position. Does this sound correct to someone familiar with ETNs?

[Park]

The last time I looked at the levered ETNs, some of them had small asset bases. I would be concerned that such ETNs would be closed.

For the retail investor, futures and options can basically be used only on US stock indices. Please correct me if I'm wrong, but the liquidity of nonUS stock indices makes transaction costs high for them. If you lever US stock indices (or any security), your returns will be magnified. I would be concerned that the US stock market is not cheap. It is certainly possible that 10 years from now, you will have magnified a negative return.

[boggler]

Are there any leveraged stock index funds that are appropriate for the long term (leveraged ETFs rebalance daily and will lead to poor results). I'm young and would love to increase my exposure to equities and am willing to increase my risk to do so.

Sounds like a good way to be broke for the rest of your life, but good luck nonetheless.

Here's my argument:
On this forum, and in many other Boglehead-y places, we all talk about the benefits of index investing. We also talk about the benefits of careful asset allocation. For young investors, one of the commonly-recommended strategies is to invest 80% in stocks, and 20% in bonds. We do this in full acknowledgement of the risks involved, but also in the hope that over time, the market will go up and we will be rewarded for those risks.

If this is the case, I'd like to argue that the amount we choose to invest is arbitrary. If we choose to invest $1000 ($800 stocks, $200 bonds), why not $1001, or why not $2000? Usually the answer is that we don't have more to invest, but what if you did? If you buy VTI and VXUS, for example, the amount of risk you choose is similarly arbitrary. Why does it always happen to be 1x leverage? If you're willing to take more risk, why not 1.5x? If there were a theoretical financial product that was almost as low-cost as a diversified stock/bond portfolio of Vanguard index funds, but had 1.5x-2x leverage, would you invest in it?

In addition to picking the dollar amount and the asset allocation, I'm suggesting that we should pick the leverage amount as well.

I'd love to hear your thoughts.

[Wolkenspiel]

I'd like to argue that the amount we choose to invest is arbitrary. If we choose to invest $1000 ($800 stocks, $200 bonds), why not $1001, or why not $2000? Usually the answer is that we don't have more to invest, but what if you did? If you buy VTI and VXUS, for example, the amount of risk you choose is similarly arbitrary. Why does it always happen to be 1x leverage? If you're willing to take more risk, why not 1.5x? If there were a theoretical financial product that was almost as low-cost as a diversified stock/bond portfolio of Vanguard index funds, but had 1.5x-2x leverage, would you invest in it?

In addition to picking the dollar amount and the asset allocation, I'm suggesting that we should pick the leverage amount as well.

I'd love to hear your thoughts.

I had a similar thought recently. Most Bogleheads are perfectly happy with cash allocations in the [0,0.25] range, but expect imminent doom when stepping into [...,-0] land (beyond investing while carrying a mortgage). In principle, this seems somewhat arbitrary.

However, there are two observations that give me pause. One is a recent proliferation of posts bringing up leverage and asking, why not? That is a little suspicious.

The other comes from a look at the charts of various leveraged products, like e.g. the aforementioned PIMCO funds and leveraged ETFs. You will see that many of these products had a fantastic run since the depths of the 2008/2009 crash (where my uninformed guess is that this success is related to the cheapness of credit, not that they suddenly figured out how to use leverage effectively). For entertainment, you could look at the returns of a 3x leveraged stock/long treasury ETF buy-hold-rebalance portfolio. Contrary to common wisdom, this would have worked fantastically well. Over the last years, leveraged ETFs have done a remarkable job of doing what they are supposed to do. Rebalancing and some margin could easily be used to get around their supposedly fundamental flaw of "only" replicating daily returns.

But at this point I would be very worried about a) being a few years late to the party and b) not being able to gracefully exit a leveraged strategy if rising interest rates should coincide with a dropping stock and bond market (I didn't see any evidence that the PIMCO "PLUS" funds or leveraged ETFs do much good in a "normal" interest rate environment).

Unlike most Bogleheads I would still consider taking a fixed-low-interest loan and investing in my desired asset allocation, but it is hard to do that on a scale that would make a large difference for most people. For small portfolios, the savings rate will be the decisive factor, and for large portfolios it will be difficult to get enough leverage to make much of a difference.

[MN Finance]

I agree that some allocations, macro or micro might seem arbitrary, and to a certain extent they are. As they say, the enemy of a good plan... That said, there is concrete data on what past risk/return characteristics have been for portfolios of differnt risks. MPT maybe be debated, but how investments are combined is not arbitrary.

Again, if getting a higher return than the "market" is a goal, that's clearly not hard. Leverage OTOH inherantly creates problems, most noticably costs. If there's an entire investment culture devoted to analyzing a portfolio and squeezing 10-20pbs of cost out because of the imapact that has on long term compounding, then adding 10 fold that cost to attempt leverage dramatically increases cost beyond reasonable levels and risk goes up disproportionately

[Clive]

LETF's, Futures, Options are all much the same in that they provide the potential to borrow to invest.

For futures and options you lock in at a fixed borrowing rate for the term at the time of purchase, whilst for LETF's the rate floats daily.

Typically LETF's cost to borrow is something around 3 month LIBOR+0.6%, which broadly averages something around the return from 2 year treasury yields.

If you borrow the same amount again as you would have invested in the 1x (underlying) in order to buy 200% total exposure, then you have those borrowing costs overheads, coupled with perhaps the funds charging 1% to manage the position, plus rolling (trading) costs. To end up with something that has twice the daily average gain/loss and twice the daily standard deviation (volatility). Double the arithmetic average and standard deviation and on a compounded basis (geometric) you'll end up with a proportionately smaller gain compared to the 1x.

The way to potentially scale up gains by using leverage is to target the same exposure to the underlying that you would have using the 1x, and invest the surplus with a target to better the cost of borrowing (LIBOR+0.6%, or 2 year treasury yields).

50% in 2x LETF, 50% in 2 year Treasury, will approximate 100% in 1x. If the 50% in 2 year Treasury is invested elsewhere and achieves >2 year Treasury rewards, you'll tend to have achieved > 100% stock reward.

There's a natural tendency to think that as stocks generally provide > 2 year Treasury gains, that investing the 50% in stocks i.e. the same asset, you'll achieve the objective. But correlations etc all have a bearing and investing in what is in effect has a 1.0 (perfect) correlation combined with volatility etc destroys that potential. More generally you want to hold asset(s) that move counter direction (low/no/inverse correlation). If you invest all 200% in the same underlying asset (stock), broadly you'll just end up with the same geometric (compound) gain, but have endured twice the volatility (standard deviation) during the interim period (depending on actual start and end dates there's wide volatility in the 'same gain' - at times it might be ahead, at other times lag. For some asset allocations having wild volatility can be a benefit (greater rebalance potential benefits if individually the assets have wild volatility and inverse correlations)).

With Options you might buy a contract that will provide you with twice the number of stocks at a future date. Some factors that will be taken into account when the price of that option is agreed (bought/sold) are the volatility, expected cost of borrowing (interest rate) etc. over that term. The fact that interest rates are relatively low at present somewhat hides those costs. In another era of higher interest rates the cost of borrowing would be higher.

If you hold a more volatile stock/asset - perhaps Small Cap Value for instance, then you also gain some leverage like exposure - higher arithmetic average, higher standard deviation.

As a guide, here are some 1 month, 3 month, 6 month and 12 month LIBOR figures

Code: Select all

   1mo   3mo   6mo   12mo
September of 1989    9.06   9.13   9.06   9.00
October of 1989    8.70   8.69   8.44   8.38
November of 1989    8.81   8.50   8.31   8.25
December of 1989    8.50   8.38   8.31   8.23
January of 1990    8.31   8.38   8.44   8.63
February of 1990    8.38   8.38   8.44   8.69
March of 1990    8.38   8.50   8.69   8.94
April of 1990    8.56   8.75   9.00   9.38
May of 1990    8.31   8.38   8.50   8.75
June of 1990    8.33   8.38   8.44   8.50
July of 1990    8.06   8.05   8.05   8.11
August of 1990    8.13   8.19   8.19   8.31
September of 1990    8.30   8.38   8.42   8.50
October of 1990    7.94   8.06   8.06   8.06
November of 1990    9.13   8.52   8.38   8.19
December of 1990    7.64   7.58   7.56   7.56
January of 1991    6.97   7.13   7.13   7.31
February of 1991    7.06   6.89   6.89   7.06
March of 1991    6.33   6.38   6.53   7.00
April of 1991    6.08   6.19   6.31   6.75
May of 1991    5.95   6.06   6.19   6.63
June of 1991    6.08   6.25   6.56   7.00
July of 1991    5.95   6.06   6.31   6.63
August of 1991    5.75   5.75   5.88   6.00
September of 1991    5.50   5.69   5.69   5.81
October of 1991    5.25   5.38   5.36   5.50
November of 1991    4.81   5.00   4.94   5.06
December of 1991    4.24   4.25   4.25   4.38
January of 1992    4.14   4.19   4.25   4.63
February of 1992    4.25   4.25   4.38   4.75
March of 1992    4.25   4.38   4.55   5.06
April of 1992    3.97   4.08   4.27   4.70
May of 1992    4.02   4.08   4.25   4.75
June of 1992    3.92   3.95   4.13   4.38
July of 1992    3.39   3.45   3.63   3.75
August of 1992    3.50   3.52   3.63   3.75
September of 1992    3.19   3.28   3.31   3.38
October of 1992    3.28   3.63   3.64   3.94
November of 1992    3.17   3.89   3.89   4.14
December of 1992    3.34   3.45   3.64   4.08
January of 1993    3.20   3.31   3.44   3.75
February of 1993    3.20   3.22   3.33   3.58
March of 1993    3.20   3.27   3.38   3.63
April of 1993    3.14   3.20   3.31   3.56
May of 1993    3.20   3.31   3.44   3.75
June of 1993    3.20   3.33   3.56   3.78
July of 1993    3.19   3.31   3.56   3.78
August of 1993    3.20   3.25   3.44   3.56
September of 1993    3.19   3.38   3.38   3.53
October of 1993    3.19   3.45   3.50   3.69
November of 1993    3.58   3.50   3.52   3.78
December of 1993    3.30   3.38   3.50   3.81
January of 1994    3.14   3.25   3.39   3.70
February of 1994    3.59   3.75   4.00   4.34
March of 1994    3.70   3.94   4.25   4.75
April of 1994    3.94   4.25   4.63   5.25
May of 1994    4.38   4.63   5.00   5.52
June of 1994    4.56   4.88   5.25   5.83
July of 1994    4.52   4.88   5.33   5.83
August of 1994    4.88   5.00   5.33   5.81
September of 1994    5.00   5.44   5.69   6.19
October of 1994    5.08   5.69   6.00   6.56
November of 1994    6.00   6.08   6.44   7.08
December of 1994    5.98   6.50   7.00   7.75
January of 1995    6.08   6.33   6.69   7.25
February of 1995    6.13   6.25   6.44   6.75
March of 1995    6.14   6.27   6.44   6.75
April of 1995    6.08   6.19   6.31   6.56
May of 1995    6.06   6.06   6.06   6.06
June of 1995    6.08   6.00   5.88   5.77
July of 1995    5.88   5.89   5.88   5.88
August of 1995    5.91   5.91   5.94   5.95
September of 1995    5.92   5.99   5.99   5.97
October of 1995    5.84   6.01   5.95   5.88
November of 1995    6.03   5.91   5.74   5.67
December of 1995    5.74   5.66   5.56   5.45
January of 1996    5.47   5.44   5.34   5.20
February of 1996    5.35   5.31   5.29   5.27
March of 1996    5.45   5.49   5.52   5.70
April of 1996    5.45   5.49   5.42   5.83
May of 1996    5.45   5.52   5.64   5.98
June of 1996    5.52   5.63   5.84   6.17
July of 1996    5.49   5.70   5.92   6.24
August of 1996    5.43   5.54   5.74   6.06
September of 1996    5.44   5.65   5.75   5.99
October of 1996    5.38   5.52   5.58   5.72
November of 1996    5.39   5.52   5.55   5.70
December of 1996    5.55   5.59   5.62   5.79
January of 1997    5.46   5.59   5.71   5.95
February of 1997    5.47   5.56   5.68   5.95
March of 1997    5.72   5.81   5.96   6.28
April of 1997    5.70   5.88   6.08   6.45
May of 1997    5.71   5.83   6.01   6.29
June of 1997    5.72   5.81   5.94   6.14
July of 1997    5.64   5.74   5.89   5.98
August of 1997    5.68   5.74   5.86   6.08
September of 1997    5.67   5.78   5.85   6.01
October of 1997    5.63   5.77   5.81   5.92
November of 1997    5.77   6.02   6.04   6.11
December of 1997    5.85   5.99   6.01   5.67
January of 1998    5.70   5.76   6.04   5.77
February of 1998    5.79   5.78   5.78   5.84
March of 1998    5.72   5.76   5.80   5.91
April of 1998    5.69   5.77   5.87   6.02
May of 1998    5.70   5.74   5.81   5.93
June of 1998    5.75   5.79   5.87   5.94
July of 1998    5.70   5.76   5.82   5.90
August of 1998    5.73   5.71   5.69   5.65
September of 1998    5.40   5.42   5.36   5.19
October of 1998    5.28   5.35   5.13   4.87
November of 1998    5.05   5.38   5.28   5.24
December of 1998    5.12   5.17   5.17   5.21
January of 1999    4.95   5.03   5.04   5.11
February of 1999    5.00   5.07   5.17   5.41
March of 1999    4.94   5.01   5.08   5.31
April of 1999    4.90   4.99   5.08   5.30
May of 1999    4.93   5.05   5.19   5.50
June of 1999    5.22   5.36   5.63   5.80
July of 1999    5.18   5.32   5.68   5.84
August of 1999    5.37   5.51   5.91   6.02
September of 1999    5.40   6.08   5.97   6.05
October of 1999    5.41   6.22   6.14   6.31
November of 1999    6.50   6.12   6.06   6.26
December of 1999    5.83   6.01   6.14   6.51
January of 2000    5.86   6.05   6.24   6.66
February of 2000    5.91   6.10   6.33   6.76
March of 2000    6.13   6.29   6.53   6.97
April of 2000    6.20   6.39   6.61   6.96
May of 2000    6.64   6.62   7.06   7.45
June of 2000    6.65   6.78   7.01   7.21
July of 2000    6.63   6.72   6.89   7.05
August of 2000    6.63   6.68   6.83   6.98
September of 2000    6.62   6.82   6.76   6.81
October of 2000    6.62   6.76   6.72   6.73
November of 2000    6.83   6.74   6.68   6.62
December of 2000    6.57   6.40   6.21   6.00
January of 2001    5.62   5.52   5.36   5.28
February of 2001    5.28   5.10   4.96   4.93
March of 2001    5.08   4.88   4.71   4.67
April of 2001    4.44   4.31   4.23   4.33
May of 2001    4.06   4.00   3.99   4.26
June of 2001    3.84   3.79   3.83   4.06
July of 2001    3.76   3.68   3.69   3.84
August of 2001    3.58   3.49   3.48   3.60
September of 2001    2.64   2.60   2.53   2.65
October of 2001    2.32   2.23   2.17   2.31
November of 2001    2.15   2.08   2.10   2.49
December of 2001    1.88   1.88   1.98   2.45
January of 2002    1.83   1.86   1.99   2.42
February of 2002    1.88   1.92   2.07   2.50
March of 2002    1.88   2.03   2.33   3.01
April of 2002    1.84   1.91   2.10   2.61
May of 2002    1.84   1.90   2.09   2.63
June of 2002    1.84   1.86   1.95   2.25
July of 2002    1.82   1.82   1.86   2.07
August of 2002    1.82   1.82   1.82   1.94
September of 2002    1.82   1.81   1.75   1.81
October of 2002    1.74   1.70   1.62   1.66
November of 2002    1.38   1.43   1.47   1.71
December of 2002    1.38   1.38   1.38   1.45
January of 2003    1.34   1.35   1.35   1.48
February of 2003    1.33   1.34   1.34   1.37
March of 2003    1.31   1.29   1.26   1.34
April of 2003    1.32   1.31   1.29   1.36
May of 2003    1.32   1.28   1.22   1.22
June of 2003    1.12   1.12   1.12   1.20
July of 2003    1.10   1.12   1.15   1.28
August of 2003    1.12   1.14   1.21   1.47
September of 2003    1.12   1.16   1.18   1.29
October of 2003    1.12   1.17   1.22   1.46
November of 2003    1.12   1.17   1.23   1.49
December of 2003    1.12   1.16   1.22   1.46
January of 2004    1.10   1.13   1.21   1.46
February of 2004    1.10   1.13   1.20   1.36
March of 2004    1.09   1.11   1.16   1.34
April of 2004    1.10   1.18   1.37   1.81
May of 2004    1.11   1.31   1.58   2.08
June of 2004    1.36   1.60   1.94   2.47
July of 2004    1.49   1.69   1.99   2.46
August of 2004    1.65   1.79   1.99   2.30
September of 2004    1.84   2.01   2.17   2.44
October of 2004    1.99   2.16   2.30   2.53
November of 2004    2.28   2.40   2.62   2.96
December of 2004    2.42   2.56   2.78   3.10
January of 2005    2.59   2.74   2.96   3.27
February of 2005    2.69   2.91   3.15   3.51
March of 2005    2.86   3.10   3.39   3.84
April of 2005    3.08   3.21   3.42   3.71
May of 2005    3.11   3.33   3.53   3.78
June of 2005    3.34   3.50   3.69   3.86
July of 2005    3.51   3.69   3.92   4.17
August of 2005    3.69   3.87   4.08   4.31
September of 2005    3.86   4.06   4.22   4.41
October of 2005    4.09   4.25   4.45   4.68
November of 2005    4.30   4.41   4.58   4.74
December of 2005    4.39   4.53   4.69   4.82
January of 2006    4.57   4.68   4.81   4.94
February of 2006    4.63   4.82   4.99   5.15
March of 2006    4.83   4.99   5.12   5.25
April of 2006    5.02   5.15   5.29   5.42
May of 2006    5.11   5.23   5.32   5.41
June of 2006    5.35   5.51   5.64   5.77
July of 2006    5.40   5.49   5.55   5.59
August of 2006    5.33   5.40   5.45   5.45
September of 2006    5.32   5.37   5.37   5.30
October of 2006    5.32   5.37   5.39   5.33
November of 2006    5.35   5.37   5.35   5.24
December of 2006    5.33   5.36   5.37   5.31
January of 2007    5.32   5.36   5.40   5.44
February of 2007    5.32   5.36   5.37   5.33
March of 2007    5.32   5.35   5.32   5.20
April of 2007    5.32   5.36   5.36   5.30
May of 2007    5.32   5.36   5.38   5.39
June of 2007    5.32   5.36   5.36   5.40
July of 2007    5.32   5.36   5.37   5.38
August of 2007    5.50   5.48   5.38   5.19
September of 2007    5.49   5.49   5.35   5.06
October of 2007    4.98   5.15   5.05   4.88
November of 2007    4.77   4.96   4.83   4.52
December of 2007    5.02   4.98   4.83   4.42
January of 2008    3.91   3.92   3.78   3.44
February of 2008    3.14   3.09   3.00   2.80
March of 2008    2.81   2.78   2.68   2.51
April of 2008    2.79   2.79   2.84   2.83
May of 2008    2.51   2.69   2.85   3.03
June of 2008    2.47   2.77   3.10   3.42
July of 2008    2.46   2.79   3.12   3.28
August of 2008    2.47   2.81   3.11   3.24
September of 2008    2.93   3.12   3.34   3.37
October of 2008    3.81   4.06   3.88   3.79
November of 2008    1.62   2.28   2.66   2.82
December of 2008    1.08   1.83   2.18   2.38
January of 2009    0.38   1.21   1.62   1.90
February of 2009    0.46   1.24   1.76   2.06
March of 2009    0.53   1.27   1.83   2.12
April of 2009    0.45   1.11   1.65   1.94
May of 2009    0.34   0.82   1.36   1.68
June of 2009    0.32   0.62   1.18   1.68
July of 2009    0.29   0.52   0.98   1.50
August of 2009    0.27   0.42   0.84   1.42
September of 2009    0.25   0.30   0.68   1.27
October of 2009    0.24   0.28   0.59   1.23
November of 2009    0.24   0.27   0.52   1.08
December of 2009    0.23   0.25   0.45   1.00
January of 2010    0.23   0.25   0.40   0.90
February of 2010    0.23   0.25   0.39   0.85
March of 2010    0.24   0.27   0.41   0.87
April of 2010    0.26   0.31   0.48   0.96
May of 2010    0.34   0.46   0.66   1.13
June of 2010    0.35   0.54   0.75   1.19
July of 2010    0.33   0.51   0.72   1.12
August of 2010    0.28   0.36   0.58   0.94
September of 2010    0.26   0.29   0.48   0.80
October of 2010    0.26   0.29   0.46   0.77
November of 2010    0.25   0.29   0.45   0.76
December of 2010    0.26   0.30   0.46   0.78
January of 2011    0.26   0.30   0.46   0.78
February of 2011    0.26   0.31   0.46   0.79
March of 2011    0.25   0.31   0.46   0.78
April of 2011    0.22   0.28   0.44   0.77
May of 2011    0.20   0.26   0.41   0.74
June of 2011    0.19   0.25   0.40   0.73
July of 2011    0.19   0.25   0.41   0.73
August of 2011    0.21   0.29   0.46   0.78
September of 2011    0.23   0.35   0.52   0.83
October of 2011    0.24   0.41   0.60   0.91
November of 2011    0.25   0.48   0.68   1.00
December of 2011    0.28   0.56   0.78   1.10
January of 2012    0.28   0.57   0.80   1.11
February of 2012    0.25   0.50   0.76   1.07
March of 2012    0.24   0.47   0.74   1.01
April of 2012    0.24   0.47   0.73   1.05
May of 2012    0.24   0.47   0.73   1.06
June of 2012    0.24   0.47   0.74   1.07
July of 2012    0.25   0.45   0.73   1.07
August of 2012    0.24   0.43   0.72   1.04
September of 2012    0.22   0.39   0.67   1.00
October of 2012    0.21   0.33   0.58   0.92
November of 2012    0.21   0.31   0.53   0.86
December of 2012    0.21   0.31   0.51   0.85
January of 2013    0.21   0.30   0.49   0.82

For a pictorial view, assume that small cap is perhaps 50% more volatile than SPY, such that to achieve a similar risk/reward we might invest just two thirds in small cap that we would have invested in SPY, and deposit the remainder in perhaps TIP (inflation bond ETF). Taking that a step further we might invest just 22% in a 3x small cap instead of 66% in small cap (1x). Go to etfreplay.com and select the Backtest ETF portfolio drop down, then enter TNA 22% weighting, TIP 78% weighting and compare the performance of that for SINGLE years (i.e. as though you rebalanced back to target weightings once each year) with SPY. Broadly you'll see somewhat similar patterns. If the 78% TIP holdings earned > TIP gains then the 22/78 blend would outpace 100% SPY. Or if you consider TIP to be risk-free, then your 'at-risk' exposure is just 22% instead of 100%.

In the real world you can see this sort of process occurring in the likes of 30% Small Cap Value, 70% 'safe' holdings - which might yield comparable results to a 50/50 TSM. Or Zvi Bodie/Nassim Taleb who take that further into leverage territory and might hold 10% to 15% highly speculative (perhaps something like the equivalent of TNA for instance), 85% to 90% 'safe' and that might collectively yield 50/50 TSM to 60/40 results.

A potential benefit of holding smaller exposure to more riskier (volatile) assets is that it holds a greater amount in 'reserves' that might be deployed at opportune times. It also has a fixed amount that might be lost in any single year (assuming yearly rebalancing) - such as the -10% in TNA for instance. If for example the 10% 3x stock allocation is totally lost over a 12 month period (stocks down), but the 'safe' 90% earns 5%, then at the start of the subsequent year your portfolio is down 5.5% such that rebalancing to start the next year has 9.45% allocated (relative to the original start date total investment amount) to the riskier asset at potentially a relatively low price.

[huntertheory]

I'm not suggesting this, but if you're determined to make a leveraged bet on equities, that's actually exactly what many Closed End Funds are designed to do. By being closed end they can borrow against the assets in the portfolio, whereas an open end mutual fund (and ETFs) have difficulty being leveraged (hence why many ETFs settle daily, etc.).

If you want to find a list of these, CEFConnect has a fund screener: http://www.cefconnect.com/Screener/FundScreener.aspx

You can sort that by type of fund and the amount of leverage. It's not uncommon for a leveraged Closed End Fund to have leverage up to 35% or so. Again I'm not suggesting this approach, and all the usual caveats about not only leverage/debt and volatility, but also the additional ones about active management, high fees, lack of diversification, high fees, etc, all apply. But if I was absolutely positively determined to invest for the long term in a leveraged manner (and I don't know why I would be), this is probably how I'd do it, by buying a CEF with reasonable fees and roughly 20% leverage. But again I don't actually recommend this.

[Akiva]

Again, if getting a higher return than the "market" is a goal, that's clearly not hard. Leverage OTOH inherantly creates problems, most noticably costs. If there's an entire investment culture devoted to analyzing a portfolio and squeezing 10-20pbs of cost out because of the imapact that has on long term compounding, then adding 10 fold that cost to attempt leverage dramatically increases cost beyond reasonable levels and risk goes up disproportionately

The main cost for taxable investors is the tax implications. If you buy a LEAP, then you pay long-term capital gains taxes every time you roll your position forward instead of only when you sell shares, and if you buy futures, you pay taxes on the mark-to-market value of your positions at a blended rate of 60% long-term capital gains and 40% short-term capital gains, The greater frequency of taxation can eat into your extra returns quite substantially.

I had a similar thought recently. Most Bogleheads are perfectly happy with cash allocations in the [0,0.25] range, but expect imminent doom when stepping into [...,-0] land (beyond investing while carrying a mortgage). In principle, this seems somewhat arbitrary.

However, there are two observations that give me pause. One is a recent proliferation of posts bringing up leverage and asking, why not? That is a little suspicious.

Well, this isn't a new thing. Lots of people have been saying since at least the 90s that ordinary investors didn't consider using leverage often enough. Both on a historical basis and on a forward looking basis with reasonably conservative assumptions, you'd be better off going with a more conservative portfolio (say 25/75 or 30/70 stock/bonds) and then slightly levering it than you would going with a more aggressive cash only portfolio (70/25 or 80/20). The conservative one will have a higher sharpe ratio, and thus after leverage it will have equal or higher returns for less or equal risk. (This is pre-tax, you should factor in the tax issues I mentioned above when making your plans to see that this is the case for you after taxes.)

[Clive]

Both on a historical basis and on a forward looking basis with reasonably conservative assumptions, you'd be better off going with a more conservative portfolio (say 25/75 or 30/70 stock/bonds) and then slightly levering it than you would going with a more aggressive cash only portfolio (70/25 70/30 or 80/20). The conservative one will have a higher sharpe ratio, and thus after leverage it will have equal or higher returns for less or equal risk.

Tweaking Simba's spreadsheet to compare 30% Small Cap Value, 70% 5-year-Treasury compared to 70% Total Stock Market, 30% 5-Year-Treasury



VISVX=Small Cap Value
UVT=2x Small Cap Value
VFITX=5 year Treasury
Yahoo adjusted close prices (total gains)