Should I use margin to buy a balanced fund?

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postingname
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Re: Should I use margin to buy a balanced fund?

Post by postingname »

madbrain wrote:
postingname wrote:
Johno wrote: 1. The max intraday drop in the flash crash was around 10%.
Wow. If only. :D

Check out this link:
ETF charts from flash crash

I guess you have to define what instrument type you are trading, but during the flash crash, major ETFs took major, major MAJOR hits. We're talking about losing 60-90+% intraday.
Wow, those are pretty scary charts , if accurate .
They're accurate. I had a couple of equity ETFs back then. I thought the world ended. :shock:
goldendad
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Re: Should I use margin to buy a balanced fund?

Post by goldendad »

Regarding the original question - no.
Tanelorn
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Re: Should I use margin to buy a balanced fund?

Post by Tanelorn »

MossySF wrote:
madbrain wrote:VTI (Vanguard Total Stock Market ETF) hit $0.15 intraday low from a $59.46 open ?
Anyone who was using margin against that would have been liquidated.

Good thing I was probably asleep during the flash crash, same as almost every hours that major US exchanges are open.
Was it possible to buy those ETFs for those prices at that moment? Or did were your trades just cancelled afterwards?
Yes, you could buy at those prices, but anything below around 50% off got cancelled retroactively (it was 60% I think, but I forget if it was 60% of the price or down 60%). I thought this old thread and quote summed it up pretty well:

Vanguard ETFs crack under stress
by dbonnett » Mon May 10, 2010 6:28 pm

In summation it would appear that liquidity of the Vanguard ETFs was absolutely awful, especially when reviewing the daily charts.
On the other hand, S&P futures, the SPY ETF, and even Schwab's relatively new index ETFs had no liquidity problems. If the flash crash had included the close, the mutual funds may not have been safe depending on what they decided to do about marking their NAV; as it was the market had mostly recovered and settled down by then so it hard to say since it didn't turn out to be an issue.

For someone considering margin, I would recommend paying a slight ER premium for a more liquid ETF rather than aiming for a rock bottom ER and one that might result in an unnecessary margin call in a time of stress.
Park
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Re: Should I use margin to buy a balanced fund?

Post by Park »

If someone is going to use both leveraged stock and bonds to increase return, I suggest reading p. 361-374 of "Contrarian Investment Strategies: The Psychological Edge" by David Dreman.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

goldendad wrote:Regarding the original question - no.
Is there more of a reason behind your answer? I'm hoping to have an open discussion of the risks and rewards.
Johno
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Re: Should I use margin to buy a balanced fund?

Post by Johno »

madbrain wrote:Johno,
Johno wrote: 1. The max intraday drop in the flash crash was around 10%.
1. Yes, I know the last flash crash was around 10%. We don't know what the next flash crash (if any) will be.
To me that's a no brainer.
2. I disagree strongly with that statement. I am perfectly happy having money in risky assets - like domestic, international, EM equity funds, and junk bond funds. Those investments do not require me to monitor my positions and take any specific action daily,

The strategies being talked about in this thread are far from simple, IMO, and I don't understand every fine point, but even if I did, I probably would not attempt them because I don't want the extra time commitment . I'm sure it's worth it to you and others, just like it's worth it for some landlords to rent out their properties - but those are more active investments that require you to put some work. It's logical that there would be some extra return for that work, otherwise nobody would be doing it.
3. Institutions manifestly cannot arb out the existence of bank accounts at ca. .95% when the zero duration riskless rate ~0%, because those deals persist.
I did in fact check bankrate before my last reply to verify that 0.95% bank accounts do exist. I never said they don't exist.
3. The question in my mind is - why can't some mutual fund company, or MLP, or other financial instituion, offer a product using the strategies described in this thread, capturing the same leveraged return - less costs to pay someone to do the monitoring work - but with less work for the individual investor ?
1. IMHO that's now too general a statement to be of much value as a response to my original post. I suggested 20% reserve margin. I did not say that would be enough in 100% of all conceivable cases, nothing I said suggested so. You responded, 'hey look at the flash crash of 2010', but as I pointed out that was not anywhere near a 20% margin call on ES contracts which is what we're talking about. So now you're essentially just saying 'we don't the know the future'. Who said we did?

And you've also in the latest response ignored the point about 'limit down' movement in the futures contracts after which trading halts for the day. This as well is not an absolute gtee, but an important caveat to a broad statement 'the market could move more than 20% in a day'. Yes, but a futures margin can can't necessarily be based on more than a 20% movement in a day. And if it needs one more reiteration, this is not a net leveraged position. The investor has all 100% of the cash necessary to support the position on a move down in the futures from 1971 to zero, eventually, just as if he invested the 100% in an ETF or mutual fund. He just needs some hours to move cash from bank account to futures account in case of very large sudden moves. IMO at 20%+ reserve in the brokerage account plus the 'limit down' feature of the contract and exchange makes this a very remote risk.

2. Not wanting to put the effort into fully understanding and managing this strategy is a valid point. Each person knows what their own time is worth and it varies widely, with how much they have to invest, and every other factor from there. And of course it also depends what else one is doing and how it relates to such a strategy, whether this would be the only reason one needed to be familiar w/ the markets. But that IMO is separate from risk. If one believes the incremental risk of loss of this strategy (over and above just being long physical ETF/fund for the same amount) is worth anywhere near 40bps I would stick with saying a person with that risk perception probably shouldn't be in the stock market at all. An incremental 40bps is a lot with quite minor incremental risk of of loss, when the expected real equity return is probably 4% or less with definite large risk of loss. If OTOH the person doesn't believe the strategy is a worthwhile use of their time or inclinations, that's different, and does not imply they shouldn't invest in stocks in a more hands off way.

As for vacation, you could put more money in the brokerage account during vacation and back in the bank when you return. As for personal emergency, you're now implicitly talking about the risk of a double+ size flash crash coinciding with a multi-day personal emergency. I think the general points about not having the time/inclination is more valid than those points, but isn't really a matter of risk per se.

3. As other poster pointed, out this arb already fades to a significant degree if an individual deploys enough capital into it to have to use other than the top few banks' rates at .90-ish%, $250k per bank. It seems obvious to me, if the point were really important enough to research further, that that's going to deteriorate to nothing much for any institution (even a fund selling on to retail investors) if they deploy the $100mils at least a viable ETF needs to. What's more, the point some people are itching to make on this forum in response to any suggestion of anything at all complicated (transactions costs!), would actually be true for an ETF doing this. It's not worth it to an institution to set up anything like this with ER less than the whole arb in this trade. The individual can do it for a lot less. That's why it works. If the individual doesn't want to do it, then it doesn't work.
Last edited by Johno on Sat Jul 26, 2014 11:12 am, edited 1 time in total.
Johno
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Re: Should I use margin to buy a balanced fund?

Post by Johno »

postingname wrote:
Johno wrote: 1. The max intraday drop in the flash crash was around 10%.
Wow. If only. :D

Check out this link:

I guess you have to define what instrument type you are trading, but during the flash crash, major ETFs took major, major MAJOR hits. We're talking about losing 60-90+% intraday.
The discussion was previously narrowly, and rather clearly I believe, defined as margin call on S&P E-mini stock index futures contracts. The exchanges or brokers made real time margin calls on moves of 10%, at most. And as also discussed the contracts now have a 20% 'limit down' per day, beyond which trading halts and the participants have till the next day to provide more margin*. Which is the whole idea of limit down. That's the other aspect to give a bit of thought to. Whether or not retail investors trade in future markets, institutions and independent professionals do. But they don't necessarily have all their liquidity parked in futures broker accounts. Thus unlimited margin calls would be a risk to them also (and the entire system ultimately) and so it shouldn't be a surprise that features have been developed to limit such risk.

*this is no protection against price movement per se obviously, the contract can open the next day up to 20% further below where it was when trading halted. The point of the feature is basically to give time to move money into futures brokerage accounts to meet margin calls. And again the trade discussed was specifically one where the investor has 100% cash, he's just using the spread between the best bank account rates and the implicit interest rate in the futures price to make more money.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

madbrain wrote:
Rob Bertram wrote: Most brokers will just sell your stuff instead of asking for money. In my case, even with the rules I set up it's still my allowance. The monthly contributions as well as the extra "margin call" payment still come from my allowance.
Are you excluding the possibility that "selling your stuff" won't cover it all ?
I hope I answered this question in a previous post sufficiently, but I want to revisit it and point out some features that are obvious in my mind but maybe not for someone reading this thread. Maybe I should edit the OP and include some of this information. The short answer is that you cannot lose "all" of your money doing this unless you lever too far.

I am suggesting using leverage in a conservative ("responsible") way. In the example of leveraging a 40/60 fund by 2.5x, this means that I add $1 of my money and borrow $1.50 from my broker. I invest the total amount of $2.50 in the 40/60 balanced fund. For me to lose all of my initial investment, the fund needs to lose $1/$2.50 = 40%.

Under what realistic market conditions can a 40% stock/60% bond fund lose 40% of its value? We have recently seen stocks drop by more than 50%, but that would only equate to a 20% drop in fund value. Even if stocks drop by 80%, bonds would need to drop by 13.33% for the entire portfolio to lose 40%. Individually, these conditions sound unrealistic. Combined, they sound impossible unless the financial markets as we know it changes.

There might be some years with negative returns, but I don't think it's possible to ever lose everything or to lose more than everything.
madbrain
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

Johno,
Johno wrote: 1. IMHO that's now too general a statement to be of much value as a response to my original post.
I don't think so. The risk of flash crash is inherent to the strategy being discussed here. We don't know the magnitude of what the next one might be, but we do know that flash crashes exist in this HFT world, and thus it's a risk to be aware of, but not necessarily an easy one to account for.
He just needs some hours to move cash from bank account to futures account in case of very large sudden moves. IMO at 20%+ reserve in the brokerage account plus the 'limit down' feature of the contract and exchange makes this a very remote risk.
It may be very remote, but it is still a risk. I'm really not comfortable holding an investment that may require me to do anything in a matter of hours' notice.
2. Not wanting to put the effort into fully understanding and managing this strategy is a valid point. Each person knows what their own time is worth and it varies widely, with how much they have to invest, and every other factor from there. And of course it also depends what else one is doing and how it relates to such a strategy, whether this would be the only reason one needed to be familiar w/ the markets.
Right, I'm not in the financial industry and haven't had a need to be that familiar with the details of things like futures. I have traded options before, but never on margin.
But that IMO is separate from risk. If one believes the incremental risk of loss of this strategy (over and above just being long physical ETF/fund for the same amount) is worth anywhere near 40bps I would stick with saying a person with that risk perception probably shouldn't be in the stock market at all. An incremental 40bps is a lot with quite minor incremental risk of of loss, when the expected real equity return is probably 4% or less with definite large risk of loss.
If OTOH the person doesn't believe the strategy is a worthwhile use of their time or inclinations, that's different, and does not imply they shouldn't invest in stocks in a more hands off way.
Time is a finite resource. Even if I was convinced the strategy was worthwhile - and 40 bps seems like a good incentive - I can't make any more of my time available to manage it. Monitoring is not zero-cost. The monitoring is definitely something I would need to get someone else to do. Certainly if I had to quit my (non-financial) job to do the market monitoring full-time, the lost wages would be much greater than the 40bps reduction, and I expect that would be the case for most people who hold full time jobs. If they had portfolios large enough that 40 bps is higher than their wages, then they either have very large portfolios, or very low-paying jobs, which doesn't really make too much sense.

Also, I don't think the risk of bank failure was discussed here. Even when sticking within FDIC limits in the bank accounts, it can take time to receive funds depending what happens to the institution. That time could be in the order of weeks, not hours. While the risk of bank failure may be low overall, especially if one splits the funds between multiple banks, it may be increased precisely during the times that the markets are most volatile that may trigger large margin calls.
As for vacation, you could put more money in the brokerage account during vacation and back in the bank when you return.
Yes, I suppose if the position is not net leveraged one, could withdraw 100% of the money from the bank account for planned vacations. This would reduce the annual return of course.
But this doesn't work for things like unplanned emergencies, like medical. To me it still seems like having the monitoring done by someone else is desirable.
As for personal emergency, you're now implicitly talking about the risk of a double+ size flash crash coinciding with a multi-day personal emergency. I think the general points about not having the time/inclination is more valid than those points, but isn't really a matter of risk per se.
It may be very low-probability for a personal emergency to coincide with a flash crash, but it's still absolutely a matter of risk. You can't plan personal emergencies by definition.
This is still a risk that exists with this strategy, and one that does not exist with a buy-and-hold strategy. I know if I had to monitor the markets continuously even without any personal emergency, It's the sort of thing that would worry me. I really would want someone else to do the monitoring.
3. As other poster pointed, out this arb already fades to a significant degree if an individual deploys enough capital into it to have to use other than the top few banks' rates at .90-ish%, $250k per bank. It seems obvious to me, if the point were really important enough to research further, that that's going to deteriorate to nothing much for any institution (even a fund selling on to retail investors) if they deploy the $100mils at least a viable ETF needs to. What's more, the point some people are itching to make on this forum in response to any suggestion of anything at all complicated (transactions costs!), would actually be true for an ETF doing this. It's not worth it to an institution to set up anything like this with ER less than the whole arb in this trade. The individual can do it for a lot less. That's why it works. If the individual doesn't want to do it, then it doesn't work.
Maybe "arb" was the wrong word to use here, but instead, have this strategy offered as a niche investment product for the public.
Why does an ETF require $100 millions ? This type of strategy might be better suited to something like a close-ended fund than ETF, though.

Of course the monitoring/management costs that exist for an individual would exist for an institutional investor also. It just doesn't seem like a very good use of the investor's time to monitoring just his/her own account. It seems one employee could monitor many other investors' accounts, and thus, scale and do it for much less than corresponding investor's lost wages . That would eat a little of the 40bps, sure, but should it eat all of it, when on most days all the employee needs to do is look at the market and not take any action ? And on the margin call days, place some wire transfers ? In theory, computers could do the monitoring and the employees would be needed only when funds need to be moved, and maybe not even then.
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market timer
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Re: Should I use margin to buy a balanced fund?

Post by market timer »

madbrain wrote:Of course the monitoring/management costs that exist for an individual would exist for an institutional investor also. It just doesn't seem like a very good use of the investor's time to monitoring just his/her own account. It seems one employee could monitor many other investors' accounts, and thus, scale and do it for much less than corresponding investor's lost wages . That would eat a little of the 40bps, sure, but should it eat all of it, when on most days all the employee needs to do is look at the market and not take any action ? And on the margin call days, place some wire transfers ? In theory, computers could do the monitoring and the employees would be needed only when funds need to be moved, and maybe not even then.
The most efficient setup would be for the brokerage to be attached to the high yield savings account, so that cash could be swept automatically from the savings account to the brokerage daily as futures are marked to market.
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

market timer wrote: The most efficient setup would be for the brokerage to be attached to the high yield savings account, so that cash could be swept automatically from the savings account to the brokerage daily as futures are marked to market.
Is that something brokerages will allow setting up for automatic use to meet margin calls?
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

Rob Bertram wrote: Under what realistic market conditions can a 40% stock/60% bond fund lose 40% of its value? We have recently seen stocks drop by more than 50%, but that would only equate to a 20% drop in fund value. Even if stocks drop by 80%, bonds would need to drop by 13.33% for the entire portfolio to lose 40%. Individually, these conditions sound unrealistic. Combined, they sound impossible unless the financial markets as we know it changes.
The S&P500 actually had almost 60% drawdown between 2008 and march 2009.
In a rising rate environment, i could see bond prices dropping 13%.
Rising rates should also cause stock prices to go down in theory, but perhaps not by 80%.

There might be some years with negative returns, but I don't think it's possible to ever lose everything or to lose more than everything.[/quote]

Yes, but if you have net leverage, don't the losses also get magnified 2.5x?
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Re: Should I use margin to buy a balanced fund?

Post by market timer »

madbrain wrote:
market timer wrote: The most efficient setup would be for the brokerage to be attached to the high yield savings account, so that cash could be swept automatically from the savings account to the brokerage daily as futures are marked to market.
Is that something brokerages will allow setting up for automatic use to meet margin calls?
My futures broker, ThinkorSwim, has the daily sweep type of setup with my equity broker, TDAmeritrade. Cash is swept from one account to the other based on how futures move during the day. If cash is not available, TDAmeritrade will borrow against other holdings. A margin call is issued when the combined balance is insufficient to meet the maintenance margin. The problem is that TDAmeritrade doesn't offer a high yield savings account. Perhaps some other broker does so. With the free lunch being offered, it would be a good marketing point.

Currently, I do the exact type of arbitrage being discussed here by Johno, parking the excess cash in a high yield savings account. My broker says they typically allow a few days to meet a margin call, unlike my previous broker, InteractiveBrokers, which would begin liquidating immediately. I've not had a margin call in a few years, so haven't had the chance to check. A crash-driven margin call is something that concerns me, particularly as I'm asleep during most of US trading hours. I take some comfort in the daily loss limits used by futures to guard against that sort of thing.
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

Rob Bertram wrote: Under what realistic market conditions can a 40% stock/60% bond fund lose 40% of its value? We have recently seen stocks drop by more than 50%, but that would only equate to a 20% drop in fund value. Even if stocks drop by 80%, bonds would need to drop by 13.33% for the entire portfolio to lose 40%. Individually, these conditions sound unrealistic. Combined, they sound impossible unless the financial markets as we know it changes.
The S&P500 actually had almost 60% drawdown between 2008 and march 2009.
In a rising rate environment, i could see bond prices dropping 13%.
Rising rates should also cause stock prices to go down in theory, but perhaps not by 80%.
There might be some years with negative returns, but I don't think it's possible to ever lose everything or to lose more than everything.
Yes, but if you have net leverage, don't the losses also get magnified 2.5x?
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

market timer wrote: My futures broker, ThinkorSwim, has the daily sweep type of setup with my equity broker, TDAmeritrade. Cash is swept from one account to the other based on how futures move during the day. If cash is not available, TDAmeritrade will borrow against other holdings. A margin call is issued when the combined balance is insufficient to meet the maintenance margin. The problem is that TDAmeritrade doesn't offer a high yield savings account. Perhaps some other broker does so. With the free lunch being offered, it would be a good marketing point.
Yes. This isn't the same as automatically withdrawing from an outside FDIC-insured account to meet margin calls.
For futures that are settled daily, an ACH pull with a 3 day clearing delay might not work. It seems a wire has to be initiated from the sending side.
Unless you could somehow give your bank authorization to allow your broker send wires from the bank account to brokerage account on your behalf.
But the brokerage might end up in a bind if customers end up not actually having enough funds in their FDIC accounts to meet the margin requirement.
Currently, I do the exact type of arbitrage being discussed here by Johno, parking the excess cash in a high yield savings account. My broker says they typically allow a few days to meet a margin call, unlike my previous broker, InteractiveBrokers, which would begin liquidating immediately. I've not had a margin call in a few years, so haven't had the chance to check.
Automatic liquidation certainly seems like an issue. I hope you never get another margin call !
A crash-driven margin call is something that concerns me, particularly as I'm asleep during most of US trading hours.
I'm in good company then as far as sleep :)
Are there any other risks with brokerages that haven't been explored here ? I seem to remember something happening with MF Global a few years back. If your brokerage account had been there instead, would you have escaped unscathed ?
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Re: Should I use margin to buy a balanced fund?

Post by market timer »

madbrain wrote:For futures that are settled daily, an ACH pull with a 3 day clearing delay might not work. It seems a wire has to be initiated from the sending side.
TDAmeritrade actually credits my account with ACH transfers the same day they are initiated, provided they are initiated by 5pm NY time. Back when I used IB, it took a week for an ACH to be received, so I'd have to wire money to meet margin calls, a huge pain.
Are there any other risks with brokerages that haven't been explored here ? I seem to remember something happening with MF Global a few years back. If your brokerage account had been there instead, would you have escaped unscathed ?
I didn't follow the MF Global situation closely, but agree these are risks worth considering. Perhaps the best solution is to have multiple brokerage accounts and stay far away from max leverage.
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

market timer,
market timer wrote:
madbrain wrote:For futures that are settled daily, an ACH pull with a 3 day clearing delay might not work. It seems a wire has to be initiated from the sending side.
TDAmeritrade actually credits my account with ACH transfers the same day they are initiated, provided they are initiated by 5pm NY time. Back when I used IB, it took a week for an ACH to be received, so I'd have to wire money to meet margin calls, a huge pain.
Sounds great. Are those for ACH pulls from the brokerage side ? Or ACH push from the bank side ?

I just checked out the TD ameritrade margin rates -they are currently between 6.25% and 9% depending on balance.
How can you make this work when the banks are paying such low yields ?
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Re: Should I use margin to buy a balanced fund?

Post by market timer »

madbrain wrote:market timer,
market timer wrote:
madbrain wrote:For futures that are settled daily, an ACH pull with a 3 day clearing delay might not work. It seems a wire has to be initiated from the sending side.
TDAmeritrade actually credits my account with ACH transfers the same day they are initiated, provided they are initiated by 5pm NY time. Back when I used IB, it took a week for an ACH to be received, so I'd have to wire money to meet margin calls, a huge pain.
Sounds great. Are those for ACH pulls from the brokerage side ? Or ACH push from the bank side ?

I just checked out the TD ameritrade margin rates -they are currently between 6.25% and 9% depending on balance.
How can you make this work when the banks are paying such low yields ?
They are ACH pulls are from the brokerage side.

I don't carry a margin balance like OP is considering. Rather, like Johno has been discussing, I have an unlevered position in futures, and park the excess cash in a high yield savings account or savings bonds to create what is effectively a negative expense ratio. If equity and bond valuations were more attractive, I'd be tempted to use some leverage, as OP is suggesting, but I'd do it with futures and options.
Tanelorn
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Re: Should I use margin to buy a balanced fund?

Post by Tanelorn »

madbrain wrote:I just checked out the TD ameritrade margin rates -they are currently between 6.25% and 9% depending on balance.
How can you make this work when the banks are paying such low yields ?
Those rates are ripoffs in this interest rate environment to catch optimistic short term traders who don't know better. As you've seen from Interactive's pricing (0.5-1.6%), the fair rate is considerably lower. If for some reason, you really prefer Ameritrade, most brokers will negotiate margin rates for larger accounts.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

madbrain wrote:
Rob Bertram wrote: Under what realistic market conditions can a 40% stock/60% bond fund lose 40% of its value? We have recently seen stocks drop by more than 50%, but that would only equate to a 20% drop in fund value. Even if stocks drop by 80%, bonds would need to drop by 13.33% for the entire portfolio to lose 40%. Individually, these conditions sound unrealistic. Combined, they sound impossible unless the financial markets as we know it changes.
The S&P500 actually had almost 60% drawdown between 2008 and march 2009.
In a rising rate environment, i could see bond prices dropping 13%.
Rising rates should also cause stock prices to go down in theory, but perhaps not by 80%.
Yes, and Wellesley (the 40/60 fund I have been discussing) had as much as a 21.7% NAV drop during the same period. Assuming that dividends distributed between the high and low points were used to return to the target leverage, it would have been about a 17% drop. Magnified 2.5x, that would have been roughly a 42.5% loss. This strategy is not immune to a year of losses, but I feel that it is reduced.
madbrain wrote:
There might be some years with negative returns, but I don't think it's possible to ever lose everything or to lose more than everything.
Yes, but if you have net leverage, don't the losses also get magnified 2.5x?
Of course, but remember that "losing money" is a different risk from the standard deviation which is the traditional MPT definition of risk. For example, Wellesley had an average 10-year return of 7.68% with standard deviation of 6.12. The probability of Wellesley having returns >= 0 is about 89.53%. So we're betting on a fund that goes down only 10.47% of the time. Multiplying by 2.5x does not change that probability. Subtracting loan interest does. After expenses, the average return is 16.95 with standard deviation of 15.3. The probability of 2.5x Wellesley with 1.5% margin loan rate giving returns >= 0 is about 86.61%. Still, that's only a 13.39% chance of losing money.

Compare that to the total stock market (VTSAX) which had an average 10-year return of 8.31% with standard deviation of 15.26. The probability of VTSAX having returns >= 0 is down to 70.7%. That's a 29.3% chance of losing money. From the perspective of giving negative returns, I would say that my 2.5x leveraging strategy is not nearly as risky as going 100% VTSAX. From a "losing money" perspective, this leverage strategy is about as risky as Vanguard LifeStrategy Income Fund (VASIX): avg 5.03, std dev 4.64, P( returns >= 0) = 86.09%, P(returns < 0) = 13.91%.

Again, looking back 10 years isn't long enough. I had a previous post where I back tested to 1977 which showed similar results. If there is more data from before then, I'd love to take a look.
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Re: Should I use margin to buy a balanced fund?

Post by MapleHermit »

If interest rates are low, then doing it is a steal. Then when they are high, just stop doing it.
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

MapleHermit wrote:If interest rates are low, then doing it is a steal. Then when they are high, just stop doing it.
That might sound like a good idea, but the data doesn't support it. Remember that this strategy leverages a balanced portfolio with percentage of bonds that should should capture the market rate. In the 1980's, this strategy was happily producing 30% and 40% returns while interest rates were in the double digits. And even despite high borrowing rates in the '80s and '90s, this strategy beat a pure stock portfolio 13 out of 18 years from 1982 - 1999 which was an amazing bull market for stocks.

Now, closely related to this is rising interest rates. When interest rates go up, bonds funds drop. This is the term risk that we were discussing earlier.
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Re: Should I use margin to buy a balanced fund?

Post by ogd »

Rob -- I still think your approach is wrong.

Leave aside the margin call issue for now -- let's agree it won't happen (with a little give on my side, aka the negative). The question is still, what about the part where you pay IB 1.5% floating to invest in intermediate bonds. Your response seems to be, this strategy backtests better than 100% stocks.

Well, it shouldn't. It certainly seems like a loser to me. There are a couple of factors in the outperformance, I think, one is that those Wellesley bonds were paying much more in the past, the other is that Wellesley itself has outperformed or you wouldn't be talking about it. Pay attention to the part in italic. Going forward the expectation is that Wellesley will be pedestrian. This is how it works, it's the Law of the Bogleheads if you will -- funds stop outperforming right after you commit -- and if you don't accept it, sooner or later off you go chasing Fairholme or whatever. And going forward, bonds will make two or three or four percent less than in the past, it's printed right on them.

What's far more likely is that your strategy will perform much like 100% stocks minus 1% a year or so leaked to IB (I gave you 0.5% from stock/bond decorrelation). You will survive the falls, likely and hopefully, but you will simply get less than you deserve. And IB will get more. It's simply too much. If I could lend to someone at 1.5% for zero term and with a finger on the sell button for assets backing the loan, I would. And so would all of the market. It's a great deal for IB and a not so great deal for you.

So the reason I recommend against it is the same as for recommending against active funds with high fees: no you won't go belly up, but you'll make less than alternatives. Worse still with this strategy, I'm not even sure you'd notice.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

ogd wrote:Rob -- I still think your approach is wrong.

Leave aside the margin call issue for now -- let's agree it won't happen (with a little give on my side, aka the negative). The question is still, what about the part where you pay IB 1.5% floating to invest in intermediate bonds. Your response seems to be, this strategy backtests better than 100% stocks.

Well, it shouldn't. It certainly seems like a loser to me. There are a couple of factors in the outperformance, I think, one is that those Wellesley bonds were paying much more in the past, the other is that Wellesley itself has outperformed or you wouldn't be talking about it. Pay attention to the part in italic. Going forward the expectation is that Wellesley will be pedestrian. This is how it works, it's the Law of the Bogleheads if you will -- funds stop outperforming right after you commit -- and if you don't accept it, sooner or later off you go chasing Fairholme or whatever. And going forward, bonds will make two or three or four percent less than in the past, it's printed right on them.
I agree that Wellesley (and Wellington) have a history of outperformance which might not continue. Though, that's not the reason why I picked it. I actually like Wellesley because it's a balanced fund that has been around for a long time. I don't have to look for daily data and reconstruct what a 40/60 balanced fund would do in 1974. If there were a 40% TSM / 60% TBM fund, I would happily use that instead as I feel that it is better diversified. (I am not convinced that TIBM has a place in my portfolio which is why am not considering the LifeStrategy funds.)
ogd wrote:What's far more likely is that your strategy will perform much like 100% stocks minus 1% a year or so leaked to IB (I gave you 0.5% from stock/bond decorrelation). You will survive the falls, likely and hopefully, but you will simply get less than you deserve. And IB will get more. It's simply too much. If I could lend to someone at 1.5% for zero term and with a finger on the sell button for assets backing the loan, I would. And so would all of the market. It's a great deal for IB and a not so great deal for you.

So the reason I recommend against it is the same as for recommending against active funds with high fees: no you won't go belly up, but you'll make less than alternatives. Worse still with this strategy, I'm not even sure you'd notice.
I agree that this sounds like a free lunch, so there must be something obvious that I'm missing. I couldn't find any obvious errors in my analysis, so I asked the community. We identified call risk and term risk, but nothing stood out as a risk that will bridge the gap from the 10% average total stock returns to the 15-20% that I project using leverage. There will be transactional costs that I haven't considered. I'm sure I'll learn a lot come tax time. When everything is said and done, I do think this strategy will beat 100% stocks over the long term, and it will beat it by a significant amount. So far, it feels like we've discussed the full range of possibilities.
  • We've looked at it as 100% stocks + 150% bond fund -150% margin >= 100% stocks.
  • We've looked at it as the probability that VWINX returns more than the margin: P(VWINX >= 1.5%) = 84.76%
  • I also looked at it from the perspective of my future self. What AA would I feel comfortable if I had 2x or 3x what I have now? If I borrow to get that 2x, 2.5x, or 3x now, what does the margin risk look like?
I will definitely keep everyone posted monthly on how it is going. I'm actually hoping for a bear market to happen. I'll be able to buy cheap stocks in my 401k and see how stressed my margin account becomes.
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Re: Should I use margin to buy a balanced fund?

Post by ogd »

Rob Bertram wrote:We've looked at it as 100% stocks + 150% bond fund -150% margin >= 100% stocks.
Rob: this is the crux of the matter, for me. I don't think this has been proven enough by any means. Where would the extra returns come from? I can think of a few possibilities:

1) Taking on extra term risk, with longer bonds. Here you're already facing a 5 year handicap just to break even; take much more than that and you'll get killed when interest rates rise. Which the market thinks they will, that's why it's demanding +1.6% for five year money.
2) Taking on some credit risk, as featured in Wellesley. Safe as they might be, those bonds are not backed by the US government. This is a possible source of extra returns, but in that case perhaps the fair comparison would be 110-120% stocks. How does that look?
3) More or less mysterious interactions between stocks and bonds. While this can produce a little extra (risk adjusted), I don't think it can account for the margin rates you're paying.
4) Overly favorable backtests -- looking at behaviour over periods where bonds, and those of Wellesley in particular, were much more generous than they are now.

My money is on #4. You can talk all you want about the "probabilities" of things past, but in the case of bonds at least it's objective: the interest rates now are putting a big damper on returns going forward and past results don't translate well into "probabilities", even more so than the usual disclaimers, because of that clear 2-3% handicap.

Now you add to this the extra complexity, the expenses of non-Admiral Wellesley, and the chance of margin call, small as it may be, and I don't see how it can be worth it. If you find cheaper margin as suggested in some posts above, you might be able to pull this off. But my strong feeling is that at 1.5% you're just enriching IB. Enriching your broker is something we recommend against here, perhaps the very reason for this site.
Rob Bertram wrote:I will definitely keep everyone posted monthly on how it is going. I'm actually hoping for a bear market to happen. I'll be able to buy cheap stocks in my 401k and see how stressed my margin account becomes.
This is a side topic in itself; I don't think anyone with non-trivial amounts of stock should be wishing for bear markets. Have expressed it elsewhere: http://www.bogleheads.org/forum/viewtop ... 0#p1843816
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

market timer,
market timer wrote: I don't carry a margin balance like OP is considering. Rather, like Johno has been discussing, I have an unlevered position in futures, and park the excess cash in a high yield savings account or savings bonds to create what is effectively a negative expense ratio. If equity and bond valuations were more attractive, I'd be tempted to use some leverage, as OP is suggesting, but I'd do it with futures and options.
OK, I guess I was partly confused because you are using an unlevered position, and the OP is advocating for using leverage.
And also, my understanding of futures is limited. I guess you need a margin account just to be able to settle the contracts, but you can open the position with cash, without actually borrowing.
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Re: Should I use margin to buy a balanced fund?

Post by madbrain »

ogd wrote: Now you add to this the extra complexity, the expenses of non-Admiral Wellesley, and the chance of margin call, small as it may be, and I don't see how it can be worth it. If you find cheaper margin as suggested in some posts above, you might be able to pull this off. But my strong feeling is that at 1.5% you're just enriching IB. Enriching your broker is something we recommend against here, perhaps the very reason for this site.
Also the IB margin rates are not guaranteed to remain the same. They could rise, too, making the whole exercise too costly. And if you are leveraged, this could force you to realize losses that you can't recoup.
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Re: Should I use margin to buy a balanced fund?

Post by Tanelorn »

madbrain wrote:Also the IB margin rates are not guaranteed to remain the same. They could rise, too, making the whole exercise too costly. And if you are leveraged, this could force you to realize losses that you can't recoup.
No, and they aren't guaranteed to stay as the same spread to Fed Funds either but that's the typical way such rates are quoted. Aren't the bond holders the ones who say they hope rates rise because even though they'll lose money in the short term, they'll make up for it in higher interest rates later? As long as the yield curve doesn't flatten/invert, the short term rates will be lower than long term ones and the spread even over the marked up margin rates will still be positive.

For example, Wellesley has almost a 10 year maturity for their fixed income side holding investment grade corporates. Right now, the yields/spreads look like this:

Fed Funds 0.0%
IB margin 1.5%
10 yr Treasuries 2.5%
10 yr Corporates 3.5%

So unless there are major twists in the yield curve, the bond portion is a "borrow short, lend long" trade with a 2% expected return (per dollar not counting leverage). And while there may be shorter term dislocations if rates rise, if the above spreads are roughly indicative it will still be positive even if rates change.
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Re: Should I use margin to buy a balanced fund?

Post by ogd »

Tanelorn wrote:
madbrain wrote:Also the IB margin rates are not guaranteed to remain the same. They could rise, too, making the whole exercise too costly. And if you are leveraged, this could force you to realize losses that you can't recoup.
No, and they aren't guaranteed to stay as the same spread to Fed Funds either but that's the typical way such rates are quoted. Aren't the bond holders the ones who say they hope rates rise because even though they'll lose money in the short term, they'll make up for it in higher interest rates later?
If your margin rates go up in tandem, then you're just left with the loss. It's no longer short term, but permanent. Or if you think about it in terms of raw bonds: for N years you make 3% but pay 4% interest. The upside that bondholders have is eaten by IB. This is a point I've already made several times above.


Tanerlorn wrote:As long as the yield curve doesn't flatten/invert, the short term rates will be lower than long term ones and the spread even over the marked up margin rates will still be positive.

For example, Wellesley has almost a 10 year maturity for their fixed income side holding investment grade corporates. Right now, the yields/spreads look like this:

Fed Funds 0.0%
IB margin 1.5%
10 yr Treasuries 2.5%
10 yr Corporates 3.5%

So unless there are major twists in the yield curve, the bond portion is a "borrow short, lend long" trade with a 2% expected return (per dollar not counting leverage). And while there may be shorter term dislocations if rates rise, if the above spreads are roughly indicative it will still be positive even if rates change.
The "expected return" comes from credit risk and term risk, like you've just illustrated above. The former is not likely to show up but very likely is less rewarding than stocks (Larry has made this point repeatedly). The latter is very likely (right now) to show up and eat your returns. Says the very yield curve that you're trying to profit from, inefficiently at 1.5% margin.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

ogd wrote:
Rob Bertram wrote:We've looked at it as 100% stocks + 150% bond fund -150% margin >= 100% stocks.
Rob: this is the crux of the matter, for me. I don't think this has been proven enough by any means. Where would the extra returns come from? I can think of a few possibilities:

1) Taking on extra term risk, with longer bonds. Here you're already facing a 5 year handicap just to break even; take much more than that and you'll get killed when interest rates rise. Which the market thinks they will, that's why it's demanding +1.6% for five year money.
2) Taking on some credit risk, as featured in Wellesley. Safe as they might be, those bonds are not backed by the US government. This is a possible source of extra returns, but in that case perhaps the fair comparison would be 110-120% stocks. How does that look?
3) More or less mysterious interactions between stocks and bonds. While this can produce a little extra (risk adjusted), I don't think it can account for the margin rates you're paying.
4) Overly favorable backtests -- looking at behaviour over periods where bonds, and those of Wellesley in particular, were much more generous than they are now.

My money is on #4. You can talk all you want about the "probabilities" of things past, but in the case of bonds at least it's objective: the interest rates now are putting a big damper on returns going forward and past results don't translate well into "probabilities", even more so than the usual disclaimers, because of that clear 2-3% handicap.
It's probably a little return from each of the above. So let's look at each point
1) There is some term risk inherent in Wellesley (or any balanced bond fund). Tanelorn discusses this. The spread is still positive.
2) I am fine with taking more "stock-like" credit risk on corporate bonds. As long as I can reasonably expect to avoid margin calls, I would be happy increasing my allocation to stocks or stock-like bonds. (And a margin call isn't the end of the portfolio, it's just a sign of capturing a loss.)
3) What does better risk-adjusted returns mean in the context of MPT? For example, say that fund B has better risk-adjusted returns than fund A. It means that the returns of fund B relative to its standard deviation is higher than that of A. Or Avg(B)/StdDev(B) > Avg(A)/StdDev(A). This is essentially what the Sharpe ratio tells us. All that I am saying is to buy more of fund B so that StdDev(B*) = StdDev(A). It will then ensure that Avg(B*) > Avg(A). If we look at the 3-, 5-, 10-year Sharpe ratios for VWINX compared to VTSAX, VWINX is higher by 60-90%. That agrees with the leverage returns I am estimating.
4) I would love to see some daily data from as early as the '30s and try to reconstruct what a 40/60 fund would look like. I agree that using historical data to predict future behavior has not been a successful strategy, and smarter people than I have tried. However, I think that my argument is different from that of tilting. I'm not looking for a specific sector to tilt. I am picking a balanced fund that represents a fair approximation of the total market. My premise is this: If we expect the markets to go up over the long term, then can we use margin to safely amplify that growth? To be honest, this seems similar to the argument between lump sum and dollar cost average.
ogd wrote:Now you add to this the extra complexity, the expenses of non-Admiral Wellesley, and the chance of margin call, small as it may be, and I don't see how it can be worth it. If you find cheaper margin as suggested in some posts above, you might be able to pull this off. But my strong feeling is that at 1.5% you're just enriching IB. Enriching your broker is something we recommend against here, perhaps the very reason for this site.
Well, I'm starting with $50k so that I can get the admiral version of Wellesley. The difference between investor and admiral shares is only 7 bps, but it adds up as you say. IB has tiered pricing on their margin loans. The first $100k is at 1.5% + risk-free rate, between $100k and $1M is 1% + RFR, and >$1M is 0.5% + RFR. Considering my monthly contribution and anticipated growth, the borrowing rate will trend towards 1% within the first couple years. I've already set the process in motion, and I will post monthly updates as to how the experiment performs including all costs involved.

My goal is to explore a "safe" way to leverage a low-risk fund and get better returns than the total stock market at equal or lower risk. I agree it should not be to line the pockets of my broker. However, this doesn't seem any different than paying a higher ER for a special SV or EM fund.
ogd wrote:
Rob Bertram wrote:I will definitely keep everyone posted monthly on how it is going. I'm actually hoping for a bear market to happen. I'll be able to buy cheap stocks in my 401k and see how stressed my margin account becomes.
This is a side topic in itself; I don't think anyone with non-trivial amounts of stock should be wishing for bear markets. Have expressed it elsewhere: http://www.bogleheads.org/forum/viewtop ... 0#p1843816
It is definitely another topic. For what it's worth, I am #1 on that list (high savings rate) with 25-30 years before before retirement. And the parameters of this exercise require maxing all retirement accounts before trying this at home.
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

ogd wrote:
Tanelorn wrote:
madbrain wrote:Also the IB margin rates are not guaranteed to remain the same. They could rise, too, making the whole exercise too costly. And if you are leveraged, this could force you to realize losses that you can't recoup.
No, and they aren't guaranteed to stay as the same spread to Fed Funds either but that's the typical way such rates are quoted. Aren't the bond holders the ones who say they hope rates rise because even though they'll lose money in the short term, they'll make up for it in higher interest rates later?
If your margin rates go up in tandem, then you're just left with the loss. It's no longer short term, but permanent. Or if you think about it in terms of raw bonds: for N years you make 3% but pay 4% interest. The upside that bondholders have is eaten by IB. This is a point I've already made several times above.
I think we all agree that markets go up and down. And when markets go down, we lose a little more due to margin interest. This is what Ogd is saying, I believe. I don't think anyone disagrees with that. However, Tanelorn is saying something different -- we get a risk premium that is still better than the IB margin. I understand that to mean "over the long run, we won't lose money to margin interest." It might not explain the substantial returns, but it at least sets a lower bound of risk. And, of course, another critical aspect is that the balanced fund will sell some stocks to buy "new" bonds with current market returns. The scale balances both ways. I think we all "get" that combining bonds with stocks smooths out the bumpy ride with stocks. But bonds get the same benefit. In other words, we lose a little bit when interest rates go up, but we gain more when they drop because we rebalanced.
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Re: Should I use margin to buy a balanced fund?

Post by Tanelorn »

Ogd - I see your point. You have interest rate risk, and parallel curve shifts are just losses (if up) or gains (if down).
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Re: Should I use margin to buy a balanced fund?

Post by Spec7re »

Wouldn't this strategy work better with the balanced fund made of futures. For example, 2 S&P500 E-mini futures mixed with 3 10 yr note futures. My understanding is that the financing rate, which is built into the futures, is extremely low (3 Month T Bill Low). I'm still trying to understand futures.


I was thinking of a similar strategy while I was investigating alternate ways of attaining leverage outside of real estate. It involved 5X (same as real estate) leverage on a 75/25 portfolio of 10 yr note futures/E-mini S&P 500 futures.

From 99-13, a portfolio of 75% VFITX and 25% VFINX had positive returns for all years. Backtesting 25% Large Blend with 5 yr Treasuries (10 yr not available) on Portfolio Visualizer shows a max draw down of 3%, so 5x leverage seemed pretty safe.

At first it seemed like 25% return with low risk of ruin, until I realized that the financing rate (assuming 3 month treasuries) has historically been as high as 8% which kills your returns and greatly increases your risk of ruin. I estimated 12% returns with a non-trivial risk of ruin, which doesn't seem worth it.

With current low rates, leverage seems tempting, but I feel like there is a scenario where borrowing rates rise as the portfolio takes a big hit at the same time, preventing you from ever being able to recover.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

Spec7re wrote:Wouldn't this strategy work better with the balanced fund made of futures. For example, 2 S&P500 E-mini futures mixed with 3 10 yr note futures. My understanding is that the financing rate, which is built into the futures, is extremely low (3 Month T Bill Low). I'm still trying to understand futures.
My knowledge of futures is limited, but I believe that there's no way to rebalance fractional pieces of a futures contracts. So we might have a portfolio of stock and bond futures, but it's not balanced. Rebalancing is the "magic" that gives the better risk-adjusted returns that we magnify with leverage. In addition, mutual funds with $36B assets can rebalance in ways that a retail investor cannot.

I could be biased. I prefer to buy and hold. A strategy where the only thing that I do is buy one fund is about as simple as I can make it. I'm sure that there are more complex strategies that could yield better returns. To quote Taylor Larimore, "There are many roads to Dublin."

For what it's worth, your strategy of 5yr treasuries is not very diversified in bonds. You have fair cause to be concerned about that risk.

My strategy backtests to about 16% average returns. As far as risk goes, we have to be specific. If we talk about the chance of negative returns (i.e., "losing money") for a year, I'll argue that 2.5x Wellesley is about as risky as going 60% TSM / 40% TBM with no leverage. If we only talk about standard deviation and ignore the fact that average returns are different, 2.5x Wellesley has roughly the sames standard deviation as 100% TSM.
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 »

My knowledge of futures is limited, but I believe that there's no way to rebalance fractional pieces of a futures contracts. So we might have a portfolio of stock and bond futures, but it's not balanced. Rebalancing is the "magic" that gives the better risk-adjusted returns that we magnify with leverage. In addition, mutual funds with $36B assets can rebalance in ways that a retail investor cannot.
You can use a bond ETF to gap any fractions of a futures contract. And a retail investor pays far less slippage when you do rebalance.
Last edited by lee1026 on Wed Jul 30, 2014 6:36 pm, edited 1 time in total.
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Re: Should I use margin to buy a balanced fund?

Post by Spec7re »

Does your backtest account for borrowing at 8%+ in 1990 and 5%+ in 2000 and 2007? What year is your largest loss?

I'm not sure how rebalancing would work with futures. I think it basically stays in balance because your are constantly rolling 3 10 yr note futures and 1 E-mini S&P 500. Assuming positive returns, excess cash would build up and your leverage would slowly fall from 5x. Once you had enough cash to buy a 5th future without going above 5x leverage, you buy one. The problem is your allocation must change. If you buy another 10 note future, you are now 20/80 stock/bond. If you buy another E-mini S&P 500 future, you are not 40/60 stock/bond. Alternatively, you could let your leverage fall to 2.5x and then double up on your original amount.
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

Spec7re wrote:Does your backtest account for borrowing at 8%+ in 1990 and 5%+ in 2000 and 2007? What year is your largest loss?
Yes, I backtested to 1977. The 2.5x strategy was doing well in the 80s even with double-digit borrowing rates. There were some years of 30 and 40% returns. You can use Simba's spreadsheet to backtest yourself if you're interested. Just enter 250% for Wellesley and -150% for Tbills. Subtract 2.25% (1.5x 1.5%) from the CAGAR to account for the difference between Tbills and the margin interest.

Wellesley had its worst year in 2008 with just under a 10% drop. Magnified 2.5x, the maximum annualized loss was about 28% in 2008. The largest draw was from 2008-2009 which was about 42%.
Spec7re wrote:I'm not sure how rebalancing would work with futures. I think it basically stays in balance because your are constantly rolling 3 10 yr note futures and 1 E-mini S&P 500. Assuming positive returns, excess cash would build up and your leverage would slowly fall from 5x. Once you had enough cash to buy a 5th future without going above 5x leverage, you buy one. The problem is your allocation must change. If you buy another 10 note future, you are now 20/80 stock/bond. If you buy another E-mini S&P 500 future, you are not 40/60 stock/bond. Alternatively, you could let your leverage fall to 2.5x and then double up on your original amount.
I agree. That doesn't sound like the traditional rebalancing. And it seems like a lot of complexity. I really need to spend more time understanding options and futures. They feel like they are halfway between buy-and-hold and speculation. I'll agree that buy and hold is essentially speculating that the markets will go up eventually but has no specific date. Futures tend to have a fairly specific date.
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

lee1026 wrote:
My knowledge of futures is limited, but I believe that there's no way to rebalance fractional pieces of a futures contracts. So we might have a portfolio of stock and bond futures, but it's not balanced. Rebalancing is the "magic" that gives the better risk-adjusted returns that we magnify with leverage. In addition, mutual funds with $36B assets can rebalance in ways that a retail investor cannot.
You can use a bond ETF to gap any fractions of a futures contract. And a retail investor pays far less slippage when you do rebalance.
We would have to do the same with stocks, right? Get SPY or a similar stock ETF. It sounds like a lot of work to keep everything balanced when we could let the mutual fund do it for us.
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 »

Well, on the stock side, you would never use E-minis, as they are so tax inefficient for the long term investor. So you would hold some number of SPY, some number of bond futures, and some amount of bond ETFs. Each day/week/month, you would compute where you want to be, buy/sell some SPY, and then adjust your bond holdings, by converting bond ETF to bond futures when it becomes big enough.

The idealized gain is roughly 160 basis points, as the implied repo rate on 5 treasury futures is about 20bps above federal funds rate, and IB will charge you 100bps. That is a lot of extra gains for a lot extra work.
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Re: Should I use margin to buy a balanced fund?

Post by HomerJ »

Rob Bertram wrote:I agree that this sounds like a free lunch, so there must be something obvious that I'm missing.
If your plan is fool-proof, why isn't everyone doing it? It's very simple, risk-free, and you estimate it will boost your returns 50%. I'm guessing there is something you are missing.

Here's what I suggest... Instead of actually following this method, write a book explaining it, and get other people to use this method while you get rich off the book royalties.
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

HomerJ wrote:
Rob Bertram wrote:I agree that this sounds like a free lunch, so there must be something obvious that I'm missing.
If your plan is fool-proof, why isn't everyone doing it? It's very simple, risk-free, and you estimate it will boost your returns 50%. I'm guessing there is something you are missing.

Here's what I suggest... Instead of actually following this method, write a book explaining it, and get other people to use this method while you get rich off the book royalties.
Can't I do both? :)
Maybe the people that are doing it are not sharing their idea. Isn't that the traditional argument? Perhaps I made the mistake of telling people about it. :oops:

But seriously, I use the term "free lunch" because diversification is the only free lunch in investing. And my strategy is taking advantage of the superior risk-adjusted returns that diversification gives us. To rephrase my strategy,
1) Pick a balanced fund with a high risk-adjusted return
2) Use leverage to increase the risk in accordance with my personal tolerance (say 100% total stock market).
It should be fair to conclude that I can expect a higher return from my leveraged balanced fund against a similar-risk, unbalanced fund (say 100% total stock market). Margin loan cost reduces the return but in a predictable way.

You use the term "risk-free". It seems to mean different things to different people. Maybe we need to re-evaluate our vocabulary as we talk about risk. I totally understand why standard deviation is the traditional measure of risk. It's a great statistical tool. However, we don't use standard deviation for our planning and estimation of risk tolerance. Instead, we focus on loss aversion: "How much of our portfolio are we willing to lose?"

Perhaps splitting the standard deviation into "up" and "down" would be more relevant. If we are only concerned about loss, we could focus on the "down" standard deviation. From a loss perspective, bonds are positively skewed. That is, the "down" standard deviation is lower than the "up". So the chance of losing money is much lower than the standard deviation would suggest. Similarly, stocks are negatively skewed, so the chance of losing money is higher than the standard deviation suggests. The logical conclusion is that bonds have a much higher ability to reduce "loss" risk in a balanced portfolio.

Anyway, this just goes back to MPT. Diversification gives us better risk-adjusted returns. It gives us a mechanism to reduce risk faster than reducing returns. Adding leverage allows us to increase that risk and increase returns.
lee1026
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 »

Here's what I suggest... Instead of actually following this method, write a book explaining it, and get other people to use this method while you get rich off the book royalties.
Problem is, someone else already wrote the book. Or at least papers that can be gathered into a book. What he is doing is by the textbook CAPM - own all of the assets, and use leverage to adjust risk to taste.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

Wikipedia does a good job of explaining what I'm trying to do in their Modern Portfolio Theory article under section 3.5 titled The risk-free asset and the capital allocation line (CAL). It is specifically discussing the MPT and picking an optimized risk-adjusted stock portfolio. I'm still reading, but I imagine that a similar argument can be made for a TSM/TBM efficient frontier.
Wikipedia wrote:Image
When a risk-free asset is introduced, the half-line shown in the figure is the new efficient frontier. It is tangent to the hyperbola at the pure risky portfolio with the highest Sharpe ratio. Its vertical intercept represents a portfolio with 100% of holdings in the risk-free asset; the tangency with the hyperbola represents a portfolio with no risk-free holdings and 100% of assets held in the portfolio occurring at the tangency point; points between those points are portfolios containing positive amounts of both the risky tangency portfolio and the risk-free asset; and points on the half-line beyond the tangency point are leveraged portfolios involving negative holdings of the risk-free asset (the latter has been sold short—in other words, the investor has borrowed at the risk-free rate) and an amount invested in the tangency portfolio equal to more than 100% of the investor's initial capital. This efficient half-line is called the capital allocation line (CAL), and its formula can be shown to be
Image
In this formula P is the sub-portfolio of risky assets at the tangency with the Markowitz bullet, F is the risk-free asset, and C is a combination of portfolios P and F.

By the diagram, the introduction of the risk-free asset as a possible component of the portfolio has improved the range of risk-expected return combinations available, because everywhere except at the tangency portfolio the half-line gives a higher expected return than the hyperbola does at every possible risk level. The fact that all points on the linear efficient locus can be achieved by a combination of holdings of the risk-free asset and the tangency portfolio is known as the one mutual fund theorem,[10] where the mutual fund referred to is the tangency portfolio.
The emphasis (underline) is mine. From what I understand, any line connecting the risk-free rate on the Y-axis to a portfolio creates a capital allocation line. The capital allocation line with the steepest slope is called the capital market line. As Lee10206 says, this is basic textbook stuff.

History (mostly for my benefit): The MPT was introduced by Harry Markowitz when he published a paper titled "Portfolio Selection" in 1952. In 1958, James Tobin published the idea of adding a risk-free asset to the MPT which allowed investors to pick their risk. He argued that the risk-free asset is independent of the risky portfolio and introduced The Separation Theorem. He calls the tangency point where the capital market line touches the efficient frontier the "super-efficient portfolio." A couple years later, William Sharpe published the Capital Asset Pricing Model (CAPM) and expanded on Tobin's idea. Sharpe showed that under ideal conditions (no taxes, trading costs, efficient markets, etc.) that Tobin's super-efficient portfolio is the market portfolio (TSM - cap weighted) and that ideal portfolios lie along the capital market line. Sharpe argued that optimal investors can pick their level of risk by leveraging or de-leveraging the market portfolio.

Of course, all of the above results from Markowitz, Tobin, and Sharpe were in the context of building the ideal stock portfolio. I think that most Bogleheads agree that TSM is a core holding, so maybe this is nothing new. As I mentioned in the first paragraph, I think a similar argument can be made for a TSM/TBM efficient frontier. Wellesley might not be the super-efficient portfolio, but it's the closest that I've seen.

There are some fairly amazing things that we can say about the capital market line. Except for the tangency point on the efficient frontier, every other point on the EF is below the capital market line. Specifically, we could slightly leverage the super-efficient portfolio and match 100% stock returns but with much lower risk. Or we can moderately leverage the super-efficient portfolio to the same risk as 100% stocks and rightfully expect higher returns.

Of course, leverage has its own risks (like margin call), but it seems like leverage could be a powerful investing tool when used responsibly.

Risk: Both MPT and CAPM assume a uniform distribution and define risk as the standard deviation. However, financial instruments are not normally distributed. At best, they are skewed which makes standard deviation less effective as a tool for fair risk measurement. Stocks generally are negatively skewed. That is, they have moderate upside but large swings of downside. On the other hand, bonds are positively skewed.

It seems that we as humans fear loss more than we enjoy gains. This makes a strong case for only measuring risk in terms of loss and allowing any variation in positive returns. Leveraged portfolios are also susceptible to margin call, so managing the downside is doubly important. There is an extension to MPT called Post-Modern Portfolio Theory (PMPT) that uses downside risk instead of standard deviation. In addition, it uses the Sortino ratio instead of the Sharpe ratio. The argument for using PMPT is that it focuses on loss and does not penalize growth, so we can carefully craft a portfolio with tightly bound lower risk.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

For those interested, I have started my experiment with a margin account using Interactive Brokers. IB likes to sit on bank transfers for 4 business days, so setup and funding took a little longer than I wanted. Anyway, money was finally available after close on 6th of August, so I was able to buy my first set of Wellesley on the 7th. I need to hold any mutual fund for 30 days before I can borrow against it. That would make the 8th of September the first trading day that I can begin using leverage in this account.

I will post monthly updates with totals as well as fees. If there's a better format, I'm open to suggestions.
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ogd
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Re: Should I use margin to buy a balanced fund?

Post by ogd »

Rob: I wish you good luck, of course. However, to temper your enthusiasm about MPT remember that you are borrowing at 1.5% above risk free rate (in direct contrast to your underlined passage) and that needs to be overcome somehow. As I mentioned repeatedly, I don't see the efficiency interplay between stocks and bonds overcome this much of a handicap, nor do I think you can benefit from interest risk and credit risk (to bring you back above 1.5% for bonds) for free in this argument. Interest rate risk in particular is almost guaranteed to hit you in the next 3-5 years, says the market, and you'd better be ready for it.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

Thanks!

For what it's worth, IB's tiered margin interest rate tops at +1.5%. For any substantial amount, people will be in the +1% tier, maybe some into the +0.5%. After a couple of years, it will average to about 1.2% for this experiment.

The risk-free rate isn't necessarily the T-bill rate, though that is the easiest one to use. There are currently a number of high-interest savings accounts paying around 1%. One could argue that the real risk-free rate is around 1% which is fairly close to the actual borrowing rate.
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ogd
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Re: Should I use margin to buy a balanced fund?

Post by ogd »

Rob: among the assets you're actually using, 0.1% is the risk-free rate.

Outside the bond market, there exists this 1% free lunch, but you're not sitting at that table. Your bonds are priced based on the 0.1% plus risks, make no mistake about it. There are proposals above to specifically target that free lunch, towards which I'm a lot more optimistic. I'd also be a lot more optimistic about a 0.5% rate, but 1.5% is just too darn much. You yourself would probably admit, if forced to have an opinion, that a borrowing rate of say 5% would kill this idea, so it can't be reasoned about in the absolute and a low borrowing rate is paramount.
lee1026
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 »

Implied interest rates on the e-mini is around .4%, so if anyone have access to anything cheaper, they are turning down free money.
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Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram »

ogd wrote:Rob: among the assets you're actually using, 0.1% is the risk-free rate.
I'm not sure that I follow. I could be mistaken, but the efficient frontier is the mean and variance calculated from performance of assets over a long period. Sure, there was a risk-free rate for each time segment in the sample, but it changes. The risk-free rate for the capital market line is today's rate. And I'm saying that today's rate isn't the T-bill rate (about 0.09%) but something slightly higher.

Image
Spec7re
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Re: Should I use margin to buy a balanced fund?

Post by Spec7re »

lee1026 wrote:Implied interest rates on the e-mini is around .4%, so if anyone have access to anything cheaper, they are turning down free money.
How did you find that? Do you know what the implied interest rate on 10 yr note futures is? I'm investigating a similar strategy that involves leveraging an 80/20 Larry portfolio using treasury futures.

Does anyone know how to find historical data on the return of rolling 10 yr note futures? I can't find anything from before 2009. My backtests currently use VFITX - 3 mo Tbill which I'm pretty sure is not accurate.

I think the downfall of a strategy like this is inflation. If we suddenly got hit with inflation, along with rapidly rising interest rates to counter it, we could see pretty heavy negative returns from both stocks and bonds, accompanied by much higher borrowing rates.

A 4x leverage version of this portfolio might look something like this:
1 10 yr note future face valued at 100k (maybe this should count as 125k given the current price quote)
6.25k cash buffer
12.5k VBR
9.375k VSS
3.125k VWO
125k invested with 31.25k

Buy and sell VBR, VSS, VWO, and IEI to keep portfolio in balance.
Add more futures as needed.

Backtests look pretty, but I'm not sure if I'm really simulating the futures return correctly. The portfolio return seems to equal the std dev, and they increase 1:1 with leverage. The down std dev is really low. 1972-1982 is the roughest period due to rising rates. I do not plan to implement this strategy; I'm mostly just playing around.
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