Can I emulate a riskier AA using leverage?

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sarabayo
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Can I emulate a riskier AA using leverage?

Post by sarabayo » Wed Mar 13, 2019 5:30 am

This is probably a dumb question, but hey, it's the middle of the night and I'm bored ;)

As a 30-year-old investor, my target asset allocation is 90/10 stocks/bonds, but my actual AA is hovering around 70/30, where my "bonds" are actually a 5-year CD ladder which I can't rebalance out of (because the CDs were a gift and I've been asked not to liquidate them). To rebalance from 70/30 to 90/10 purely by adding new money to equities will take many years, after which I may be too old for that allocation anyway, which seems unfortunate. So I'm looking for ideas on what to do about that.

I've been following with some interest (and incomplete understanding) the thread HEDGEFUNDIE's excellent adventure over on the other subforum, and it made me wonder -- is there some canonical way to use leverage in some part of the equity side of my portfolio in order to ratchet up my risk exposure to something akin to a 90/10 portfolio without actually selling any of my fixed-income assets? By "canonical" I mean that I want to take an amount of risk equivalent to a 90/10 portfolio, but at the same time I want to still be index investing, not betting on a beat-the-market strategy... if that makes sense.

Any ideas?

EDIT: Here's my current portfolio:
Emergency fund: $30k, split into $5k in FDRXX and $25k in VMFXX
Debt: none
Tax Filing Status: Single
Tax Rate (marginal): 24% federal, 9.3% state (but close to the 32% federal bracket, may enter it depending on self-employment side income)
State: CA
Age: 30
Desired asset allocation: 90/10
Desired international allocation: 40% (to mimic Vanguard's target retirement funds)

Current Retirement Assets (about $375k):

59.88% Taxable
  • 28.06% Vanguard Total Stock Market Index (VTSAX) (0.04%) at Vanguard
  • 31.82% 5-year biannually maturing CD ladder, avg yield 2.92%, at Fidelity
7.15% 403(b) (previous employer, at TIAA, 100% Roth):
  • 7.15% TIAA-CREF S&P 500 Index (TISPX) (0.06%)
22.33% 401(k) (current employer, at Fidelity, currently 21% traditional / 79% Roth):
  • 3.16% Vanguard 500 Index Trust (invests in VFFSX) (0.01%)
  • 0.72% Vanguard Extended Market Index Trust (invests in VSEMX) (0.04%)
  • 18.46% Vanguard Total International Stock Market Index Trust (invests in VTISX) (0.07%)
10.63% Roth IRA (at Vanguard):
  • 1.66% Vanguard Extended Market Index (VEXAX) (0.08%)
  • 8.98% Vanguard Total International Stock Market Index (VTIAX) (0.11%)
Current asset allocation is 68.18% stocks, 31.82% fixed income (CDs). Current international allocation within stocks is 40.24%.

Contributions:

New Annual Contributions, starting in 2019:
  • $22.5k pre-tax to 401(k) (includes employer match)
  • $24.5k Roth to 401(k) via mega backdoor
  • $6k Roth to IRA via backdoor
  • $20k (very rough estimate) Roth to Solo 401(k) via mega backdoor
  • $25k (very rough estimate) to taxable from vesting RSUs (only for the next couple years)
  • Anything else I can spare after annual expenses without eating into my emergency fund will also go to taxable
Other available funds in retirement accounts (omitting uninteresting ones):

403(b):
  • TIAA-CREF International Equity Index (TCIEX) (0.06%)
  • TIAA-CREF Small-Cap Blend Index (TISBX) (0.06%)
  • Vanguard Short-Term Bond Index (VBITX) (0.05%)
  • Other stuff through a brokerage linking option
401(k):
  • Vanguard 500 Index Trust (invests in VFFSX) (0.01%)
  • Vanguard Total Bond Market Index Trust (invests in VTBSX) (0.03%)
  • Vanguard Target Retirement funds, 2015-2065 and Income (all 0.05%)
  • Galliard Stable Value Fund (0.31%)
  • Other stuff through a brokerage linking option
Last edited by sarabayo on Wed Mar 13, 2019 6:11 am, edited 1 time in total.

HEDGEFUNDIE
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Re: Can I emulate a riskier AA using leverage?

Post by HEDGEFUNDIE » Wed Mar 13, 2019 5:34 am

How large is your portfolio?

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vineviz
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Re: Can I emulate a riskier AA using leverage?

Post by vineviz » Wed Mar 13, 2019 5:43 am

sarabayo wrote:
Wed Mar 13, 2019 5:30 am
I've been following with some interest (and incomplete understanding) the thread HEDGEFUNDIE's excellent adventure over on the other subforum, and it made me wonder -- is there some canonical way to use leverage in some part of the equity side of my portfolio in order to ratchet up my risk exposure to something akin to a 90/10 portfolio without actually selling any of my fixed-income assets? By "canonical" I mean that I want to take an amount of risk equivalent to a 90/10 portfolio, but at the same time I want to still be index investing, not betting on a beat-the-market strategy... if that makes sense.
Sure.

The easiest and, IMHO, most efficient way to do this is to move 10% of your portfolio into UPRO (ProShares UltraPro S&P500). It is more-or-less 300% equity while the rest of your equity holdings are 100%, so (.10 * 300%) + (.6 * 100%) = 90%.

At your age, equity exposure anywhere between 90% and 150% is probably okay depending on your risk tolerance so you might not need to get too aggressive about rebalancing unless UPRO really moves a lot.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Daryl
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Re: Can I emulate a riskier AA using leverage?

Post by Daryl » Wed Mar 13, 2019 5:47 am

90% TIPS/10% LEAP Call Option Portfolio

This was one of the first links that came up with I was looking for prior discussions on Zvi Bodie. Honestly though, this all seems rather complicated, or maybe I'm too much of a lazy investor. Either way, I'd be looking at the maturation date of the CDS, their yield, prevailing rates on similar fixed income securities, and then making a decision as to whether or not they should stay or go. It isn't clear if these CDs were part of an inheritance or similar. Personally, a large inheritance could impact my need, willingness, or ability to take risk, and I might be OK with a lower equity allocation (despite what others might suggest for someone in their 30's)

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rmelvey
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Re: Can I emulate a riskier AA using leverage?

Post by rmelvey » Wed Mar 13, 2019 6:07 am

The 2x, 3x, ETFs are the easiest way to get more exposure to equities. Your only other alternatives would be a margin account at interactive brokers, rolling futures contracts (annoying, easy to fall into a behavioral trap), or using options.

If I needed leverage in a retirement account I would lean towards the levered ETFs, in a taxable account I would look at plain vanilla margin at interactive brokers.

All of this said, this is creating more complexity in your portfolio for something that is adding more risk at a higher cost than stocks bought with cash. For making such a minor tweak to your portfolio I'm not sure this is worth opening the can of worms.

Topic Author
sarabayo
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Re: Can I emulate a riskier AA using leverage?

Post by sarabayo » Wed Mar 13, 2019 6:25 am

HEDGEFUNDIE wrote:
Wed Mar 13, 2019 5:34 am
How large is your portfolio?
Sorry, edited it into the OP. Sitting at around $375k right now, of which $120k is in the CD ladder.
Daryl wrote:
Wed Mar 13, 2019 5:47 am
Either way, I'd be looking at the maturation date of the CDS, their yield, prevailing rates on similar fixed income securities, and then making a decision as to whether or not they should stay or go. It isn't clear if these CDs were part of an inheritance or similar. Personally, a large inheritance could impact my need, willingness, or ability to take risk, and I might be OK with a lower equity allocation (despite what others might suggest for someone in their 30's)
Thankfully not an inheritance, just a gift from my still-healthy parents. I'm just keeping the CD ladder as-is out of respect for their stated wishes -- they're more conservative investors than I am, I guess. Though perhaps one could argue that by leveraging the equity portion of my portfolio, I'd still be going against the spirit of their wishes if not the letter...

Nate79
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Re: Can I emulate a riskier AA using leverage?

Post by Nate79 » Wed Mar 13, 2019 6:37 am

Since the CD is illiquid I would not count it as part of your investable assets until you can cash them in and reallocate. It's not like you can rebalance with these CDs until you can cash them.

Topic Author
sarabayo
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Re: Can I emulate a riskier AA using leverage?

Post by sarabayo » Wed Mar 13, 2019 6:35 pm

vineviz wrote:
Wed Mar 13, 2019 5:43 am
The easiest and, IMHO, most efficient way to do this is to move 10% of your portfolio into UPRO (ProShares UltraPro S&P500). It is more-or-less 300% equity while the rest of your equity holdings are 100%, so (.10 * 300%) + (.6 * 100%) = 90%.

At your age, equity exposure anywhere between 90% and 150% is probably okay depending on your risk tolerance so you might not need to get too aggressive about rebalancing unless UPRO really moves a lot.
Thanks. I'm not totally clear on how the math works for determining the effective asset allocation numbers for portfolios that include leveraged securities. I see how you get 90% for equities, but how do you get 10% for fixed-income? My CDs are still 100% equity, and make up 30% of my portfolio, so by your math, doesn't that mean my fixed-income allocation is 0.3 * 100% = 30%, still? Then is my portfolio a "90/30" allocation? And rescaling that to be out of 100, doesn't that actually mean a 75/25 allocation? :confused

Interesting that you say that anything under 150% is OK for a 30-year-old. That seems higher than most of the rules of thumb I see around here. In fact I don't think I've ever seen anyone recommend >100% equities for any age! :)

I'm not sure what my risk tolerance is since I haven't experienced a downturn during my investment lifetime thus far, but I feel like my knowledge that the total market never goes to zero is what will keep me from panicking in a downturn. Once I'm over 100% equities, though, there is a possibility for my portfolio to go to zero, so maybe that means my risk tolerance tops out at 100% equities? Not sure.

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vineviz
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Re: Can I emulate a riskier AA using leverage?

Post by vineviz » Wed Mar 13, 2019 7:06 pm

sarabayo wrote:
Wed Mar 13, 2019 6:35 pm
Thanks. I'm not totally clear on how the math works for determining the effective asset allocation numbers for portfolios that include leveraged securities. I see how you get 90% for equities, but how do you get 10% for fixed-income? My CDs are still 100% equity, and make up 30% of my portfolio, so by your math, doesn't that mean my fixed-income allocation is 0.3 * 100% = 30%, still? Then is my portfolio a "90/30" allocation? And rescaling that to be out of 100, doesn't that actually mean a 75/25 allocation? :confused
There are a coupe of different ways to look at it, but I think the most relevant one is that the #1 goal is that your portfolio be exposed to an appropriate amount of equity risk. That's why I solved for 90% equity exposure and ignored the CDs. In other words, it's not so much the 90/10 ratio that is most important in this context, but the actual amount of equity exposure.

It's also worth mentioning that CDs aren't actually bonds: they are cash deposited in a bank account. They're not contributing any real risk to your portfolio, and .3 times zero is the same as .1 times zero.
sarabayo wrote:
Wed Mar 13, 2019 6:35 pm
Interesting that you say that anything under 150% is OK for a 30-year-old. That seems higher than most of the rules of thumb I see around here. In fact I don't think I've ever seen anyone recommend >100% equities for any age! :)
It's a conservative forum, for sure, and I'm definitely in the minority on this one.

But you can think of your situation as one in which you have essentially three significant assets: $120k in cash, $255k in stocks, and some amount in human capital (which for our purposes we can estimate as the present value of your future savings). There are some nuances around calculating this number, and you don't say exactly what you earn but let's say your current income is roughly $150k. Assuming a 20% savings rate, the PV of your future savings is something like $957k.

Follow?

So add the $375k you have in hand to the $957k in human capital and the total estimated present value of current and future savings is $1.3 million and change. If you've got an average risk aversion level, roughly 60% of that $1.3 million should CURRENTLY be invested in equities (that is, over your life cycle you should have an average allocation of 60/40).

So, you should have $775k in equity exposure at your age and income but you only have $255k. Leaving aside the dangers and costs of leveraging up a portfolio, from a maximum diversification standpoint you could be 300% in equities. In practice that's a very dangerous degree of leverage and difficult for any but the most sophisticated investor to manage. But the concepts are sound.

It's basically just time diversification in that the goal is maintain an equal amount of equity exposure each year of your career. That might mean being 150% equity when you are young and haven't yet saved much, and only 30% equity when you are retired and have not more ability to contribute more savings to your account.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

pward
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Re: Can I emulate a riskier AA using leverage?

Post by pward » Wed Mar 13, 2019 7:14 pm

Yes. You could do something like the black swan portfolio, 90% 1 year treasury bills and 10% leap options that you roll every year. That mix will produce equity like upside with a limit of ~10% nominal downside per year. I would however recommend you do a LOT of research in different forms of leverage prior to actually going down that path, so you know what you're getting into. NEVER EVER buy any investment that you don't fully understand.

Also, there's nothing wrong with having a conservative asset allocation, even as a young accumulator. In many cases, it actually has better outcomes: https://portfoliocharts.com/2016/07/25/ ... tion-plan/

HEDGEFUNDIE
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Re: Can I emulate a riskier AA using leverage?

Post by HEDGEFUNDIE » Wed Mar 13, 2019 7:41 pm

vineviz wrote:
Wed Mar 13, 2019 7:06 pm
sarabayo wrote:
Wed Mar 13, 2019 6:35 pm
Thanks. I'm not totally clear on how the math works for determining the effective asset allocation numbers for portfolios that include leveraged securities. I see how you get 90% for equities, but how do you get 10% for fixed-income? My CDs are still 100% equity, and make up 30% of my portfolio, so by your math, doesn't that mean my fixed-income allocation is 0.3 * 100% = 30%, still? Then is my portfolio a "90/30" allocation? And rescaling that to be out of 100, doesn't that actually mean a 75/25 allocation? :confused
There are a coupe of different ways to look at it, but I think the most relevant one is that the #1 goal is that your portfolio be exposed to an appropriate amount of equity risk. That's why I solved for 90% equity exposure and ignored the CDs. In other words, it's not so much the 90/10 ratio that is most important in this context, but the actual amount of equity exposure.

It's also worth mentioning that CDs aren't actually bonds: they are cash deposited in a bank account. They're not contributing any real risk to your portfolio, and .3 times zero is the same as .1 times zero.
sarabayo wrote:
Wed Mar 13, 2019 6:35 pm
Interesting that you say that anything under 150% is OK for a 30-year-old. That seems higher than most of the rules of thumb I see around here. In fact I don't think I've ever seen anyone recommend >100% equities for any age! :)
It's a conservative forum, for sure, and I'm definitely in the minority on this one.

But you can think of your situation as one in which you have essentially three significant assets: $120k in cash, $255k in stocks, and some amount in human capital (which for our purposes we can estimate as the present value of your future savings). There are some nuances around calculating this number, and you don't say exactly what you earn but let's say your current income is roughly $150k. Assuming a 20% savings rate, the PV of your future savings is something like $957k.

Follow?

So add the $375k you have in hand to the $957k in human capital and the total estimated present value of current and future savings is $1.3 million and change. If you've got an average risk aversion level, roughly 60% of that $1.3 million should CURRENTLY be invested in equities (that is, over your life cycle you should have an average allocation of 60/40).

So, you should have $775k in equity exposure at your age and income but you only have $255k. Leaving aside the dangers and costs of leveraging up a portfolio, from a maximum diversification standpoint you could be 300% in equities. In practice that's a very dangerous degree of leverage and difficult for any but the most sophisticated investor to manage. But the concepts are sound.

It's basically just time diversification in that the goal is maintain an equal amount of equity exposure each year of your career. That might mean being 150% equity when you are young and haven't yet saved much, and only 30% equity when you are retired and have not more ability to contribute more savings to your account.
A beautiful explanation of lifecycle investing which should be wiki’ed.

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sarabayo
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Re: Can I emulate a riskier AA using leverage?

Post by sarabayo » Wed Mar 13, 2019 8:09 pm

vineviz wrote:
Wed Mar 13, 2019 7:06 pm
But you can think of your situation as one in which you have essentially three significant assets: $120k in cash, $255k in stocks, and some amount in human capital (which for our purposes we can estimate as the present value of your future savings). There are some nuances around calculating this number, and you don't say exactly what you earn but let's say your current income is roughly $150k. Assuming a 20% savings rate, the PV of your future savings is something like $957k.

Follow?
HEDGEFUNDIE wrote:
Wed Mar 13, 2019 7:41 pm
A beautiful explanation of lifecycle investing which should be wiki’ed.
Hmm. This (along with the subsequent paragraphs in your post, which I omitted for brevity) is certainly an interesting way to look at it. I'm not sure how you derived the $957k number, but for what it's worth, I'm planning to save over $80k per year for at least the next few years, which is close to 3x your supposition of $30k per year (i.e. 20% of $150k), so I guess the number should be more like $2.8 million?

However, I find it very hard to confidently predict what my savings rate will look like over the entire remainder of my working life. I work in the tech industry where compensation is currently flying at record highs but may crash and burn at some point, greatly reducing my income or putting me out of work. I may change careers to something that pays less than my current field. I may become disabled and unable to work, I may opt to retire early, I may move to another country, who knows. So I find it difficult to understand how people following the lifecycle investing philosophy can be confident enough about the present value of their human capital to stake their asset allocation across their lifetime, including heavy leverage in the early years, on that number.

Am I missing something?

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vineviz
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Re: Can I emulate a riskier AA using leverage?

Post by vineviz » Thu Mar 14, 2019 11:21 am

sarabayo wrote:
Wed Mar 13, 2019 8:09 pm
Hmm. This (along with the subsequent paragraphs in your post, which I omitted for brevity) is certainly an interesting way to look at it. I'm not sure how you derived the $957k number, but for what it's worth, I'm planning to save over $80k per year for at least the next few years, which is close to 3x your supposition of $30k per year (i.e. 20% of $150k), so I guess the number should be more like $2.8 million?
Sure, and you'd want to model things as accurately as possible to make sure you were making the right decisions.

sarabayo wrote:
Wed Mar 13, 2019 8:09 pm
So I find it difficult to understand how people following the lifecycle investing philosophy can be confident enough about the present value of their human capital to stake their asset allocation across their lifetime, including heavy leverage in the early years, on that number.
Planning for the future always involves a great deal of uncertainty, but conceptually the lifecycle investing model can handle all of that. It's really just a framework for expressing those uncertainties explicitly instead of leaving them hidden as implicit assumptions.

Most people are not at "peak earnings" at age 30, but if you think you might be then you include lower (or even negative) wage growth later in life than the "average" person. If your savings rate is high now but is likely to drop in five years because of plans to have children then you model that in. You just adjust the assumptions to suit your situation, and do your best to make sure your assumptions are as close the middle of probability distributions as possible. Heck, you could even undertake a complex scenario analysis if the the benefits are worth the effort.

And, like any financial plan, you always update it routinely (annually, for most people) and definitely when circumstances change. My view is that uncertainty about the future is a reason to plan, not a reason to avoid planning.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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