Anyone actually use leverage (ei ayres and nalebuff)?

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freyj6
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Anyone actually use leverage (ei ayres and nalebuff)?

Postby freyj6 » Wed Dec 24, 2014 8:35 pm

I became interested in their theory a few months ago so I read some of their stuff and got their book. After going through it though, I'm more skeptical/disappointed. It seems like a great idea in theory -- expose yourself to twice the risk/return early in life -- but in practice, maybe not so much.

As I can see, the cons are as follows:
-About a 4-5% expense ratio
-Unable to keep buying low because a) you don't have the extra cash and b) you become over-leveraged
-Very limited realistic investment options

I did a rough (probably somewhat inaccurate) calculation with Monte Carlo simulations over 30 years, and from what I could tell -- if you take into account a 4.5% expense ratio -- yes it beats 75/25 and 90/10 lifecycle portfolios invested in the S&P or Total US Stock Market, but still does worse than a 100% stock portfolio heavily tilted towards small value or other high-risk high-return asset classes.

Does anyone here use leverage? Were you able to do it in a way where you achieve higher expected returns with lower risk than a heavily tilted portfolio?

Thanks!

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market timer
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby market timer » Wed Dec 24, 2014 9:23 pm

freyj6 wrote:As I can see, the cons are as follows:
-About a 4-5% expense ratio

How do you get a 4-5% ER? If you mean the cost of interest is 4-5%, you can do better with futures and options based on today's rates.
-Unable to keep buying low because a) you don't have the extra cash and b) you become over-leveraged

Yes, the strategy involves buying high and selling low.
-Very limited realistic investment options

You can leverage the S&P 500 fairly easily. If you want to tilt in directions where leverage is more difficult, you can use more leverage on the S&P 500 and no leverage for those other holdings.
Does anyone here use leverage? Were you able to do it in a way where you achieve higher expected returns with lower risk than a heavily tilted portfolio?

I did 7 years ago and it didn't work out so well--see their Chapter 6. Very bad timing on my part. If I'd do it again, I'd add more assets classes, including bonds and commodities.

Rob Bertram
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Rob Bertram » Wed Dec 24, 2014 10:05 pm

Does anyone here use leverage? Were you able to do it in a way where you achieve higher expected returns with lower risk than a heavily tilted portfolio?
I'm using leverage. As Market Timer suggests, I'm leveraging a balanced portfolio of stocks and bonds rather than an all stock portfolio. There's a discussion here: viewtopic.php?f=10&t=143037

  • Right now, margin interest rates start at 1.6% (and go down to 0.5%), so I'm not sure where your 4-5% number comes from.
  • The nice feature of leveraging a balanced portfolio is that you will be buying the lagging asset class, so you will be buying low(er).
  • With margin, you can buy any ETF you want. You can easily construct a 3-fund portfolio. What other asset classes are unavailable?

Park
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Park » Wed Dec 24, 2014 11:32 pm

market timer wrote:
freyj6 wrote:As I can see, the cons are as follows:
-About a 4-5% expense ratio

How do you get a 4-5% ER? If you mean the cost of interest is 4-5%, you can do better with futures and options based on today's rates.
-Very limited realistic investment options

You can leverage the S&P 500 fairly easily. If you want to tilt in directions where leverage is more difficult, you can use more leverage on the S&P 500 and no leverage for those other holdings.


Market Timer, you know considerably more about investing than I do. However, at the end of November, I took a look at options on SPY. SPY was trading at 206.98/207.00. 105.0 call expiring Dec 17/16 was 100.14/104.50. If you used the bid ask spread, the effective interest rate was 4.65%. If you used the midpoint on the option, it was 3.63%. With PE10 on the S&P500 being similar to what it was at the 2007 peak, I'm reluctant to lever the S&P500. I took a look at options on other indices, and the effective interest rates were higher (sometimes a lot higher) than on SPY. With the comparatively low volatility of the S&P500 and the liquidity of SPY, that makes sense.

I agree that futures in a tax advantaged account make sense; I'd prefer margin in a taxable account, with IB as my source of margin loans. But when it comes to options, the only options I've found where the effective interest rate makes leverage a viable option are on the S&P500, and I'm reluctant to lever it at the moment.

Please feel free to criticize me.

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market timer
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby market timer » Thu Dec 25, 2014 3:14 am

Park wrote:However, at the end of November, I took a look at options on SPY. SPY was trading at 206.98/207.00. 105.0 call expiring Dec 17/16 was 100.14/104.50. If you used the bid ask spread, the effective interest rate was 4.65%. If you used the midpoint on the option, it was 3.63%.

Because short term interest rates are well below the dividend yield on the S&P, you typically run into a problem with deep-in-the-money call options: they are most efficiently exercised just prior to the next ex-div date. I wrote a little about that here: viewtopic.php?f=10&t=143037&start=350#p2238050

What this means is that the LEAPS strategy recommended by Ayres and Nalebuff isn't attractive in this low interest rate environment. There are cheaper ways to get leverage. The result is that the market for these LEAPS is basically nonexistent. The spread you quote is ridiculously wide, over $4. There's just no reason to buy a Dec 2017 LEAPS if its effective expiration date is March 2015, the next ex-div date for SPY. Of course, you have the option of buying the Dec 2017 LEAPS and not exercising it, but that's paying more in interest than is necessary. Instead, I'd recommend futures, margin, or leveraged ETFs (rebalanced as needed). If you want to get leverage with options, you could buy a synthetic long--buy a call and sell a put with the same strike and expiration. If you choose a strike price that is near-the-money for the synthetic long, early exercise is less of a problem. Note that December 2015 calls and puts near 200 strike are rather liquid (bid/offer ~50 cents wide).

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nisiprius
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby nisiprius » Thu Dec 25, 2014 9:44 am

One particular caution I have. One of the methods Ayres and Nalebuff present--as a viable option--is the use of a 2X leveraged S&P 500 mutual fund, specifically ProShares UltraBull. One of their section heading is "Investing with ProFunds UltraBull." In an interview they mention that one of them, I forget whom, is using it personally.

I'd barely heard of leveraged funds until I read about them in their book, and when I looked into it, what I found was so disturbing that I think it was irresponsible of them to suggest this as a valid way of implement their plan, and if one of them is using this fund I have serious doubts about their competence. It seems clear that they are specifically endorsing the idea of buying and holding a kind of mutual fund whose providers say specifically that it is unsuitable for and should not be used by buy-and-hold investors.

Inverse and Leveraged ETFs

On the other hand, since I don't do this kind of investing myself it's quite possible that they're smart and I'm the idiot, of course.
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby midareff » Thu Dec 25, 2014 9:57 am

market timer wrote:
freyj6 wrote:
Does anyone here use leverage? Were you able to do it in a way where you achieve higher expected returns with lower risk than a heavily tilted portfolio?

I did 7 years ago and it didn't work out so well--see their Chapter 6. Very bad timing on my part. If I'd do it again, I'd add more assets classes, including bonds and commodities.



I tried using leverage near 15 years ago going 2X the Nasdaq. Could have made quite a bit if I had timed it right, but didn't. Still have some tax loss left. I learned... as those famous lines go ... "Once bitten twice shy." ... or those other famous lines; "Bulls will make money and bears will make money but it is the destiny of a pig to go to slaughter."

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TheTimeLord
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby TheTimeLord » Thu Dec 25, 2014 10:03 am

Funny story, the last time I used leverage was October 19, 1987. This was probably the most important days of my investing life, which was a few months old at the time. I feel like I got a decade of education in about a 30 day period starting on October 19, 1987.
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TravelerMSY
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby TravelerMSY » Thu Dec 25, 2014 2:24 pm

October 20 would have been a good time to start.

There are also single stock futures on many stocks and ETFs that can be used as a financing tool, and can be traded in an IRA. You are subject to recourse leverage (potential margin calls) unlike with the leaps.

chaz
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby chaz » Thu Dec 25, 2014 2:39 pm

My leverage is now in the Vanguard Balanced Index fund.
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Rob Bertram
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Rob Bertram » Thu Dec 25, 2014 3:31 pm

nisiprius wrote:One particular caution I have. One of the methods Ayres and Nalebuff present--as a viable option--is the use of a 2X leveraged S&P 500 mutual fund, specifically ProShares UltraBull. One of their section heading is "Investing with ProFunds UltraBull." In an interview they mention that one of them, I forget whom, is using it personally.

I'd barely heard of leveraged funds until I read about them in their book, and when I looked into it, what I found was so disturbing that I think it was irresponsible of them to suggest this as a valid way of implement their plan, and if one of them is using this fund I have serious doubts about their competence. It seems clear that they are specifically endorsing the idea of buying and holding a kind of mutual fund whose providers say specifically that it is unsuitable for and should not be used by buy-and-hold investors.

Inverse and Leveraged ETFs

On the other hand, since I don't do this kind of investing myself it's quite possible that they're smart and I'm the idiot, of course.

You're definitely not the idiot. The daily re-leveraging nature of leveraged ETFs make them perform worse in volatile times and better in trending times. This lower performance can be fixed mostly by rebalancing with an uncorrelated asset (bonds or cash). Market Timer hints at this in his post. In a different thread, Park supplied a number of great journal articles on leverage and leveraged ETFs. There are a couple articles that describe when to do this rebalancing. I can go searching for them if anyone is interested.

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Yesterdaysnews
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Yesterdaysnews » Thu Dec 25, 2014 4:14 pm

I'm interested.

freyj6
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby freyj6 » Thu Dec 25, 2014 7:17 pm

I guess I still have a lot to learn about the different options for doing this and how much they actually cost in different environments.

Maybe once I understand it better, I'll give it a shot if the market tanks 25 or 30 percent. But then of course, it could just keep going down.

It does still seem to me that with the expense ratio and the inability to buy low and hold/buy through dips, you could get a similar risk and return by loading up on risky assets like small value, micro cap, emerging markets, etc.

Johno
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Johno » Thu Dec 25, 2014 9:10 pm

market timer wrote:
freyj6 wrote:As I can see, the cons are as follows:
-About a 4-5% expense ratio

How do you get a 4-5% ER? If you mean the cost of interest is 4-5%, you can do better with futures and options based on today's rates.
-Unable to keep buying low because a) you don't have the extra cash and b) you become over-leveraged

Yes, the strategy involves buying high and selling low.
-Very limited realistic investment options

You can leverage the S&P 500 fairly easily. If you want to tilt in directions where leverage is more difficult, you can use more leverage on the S&P 500 and no leverage for those other holdings.
Does anyone here use leverage? Were you able to do it in a way where you achieve higher expected returns with lower risk than a heavily tilted portfolio?

I did 7 years ago and it didn't work out so well--see their Chapter 6. Very bad timing on my part. If I'd do it again, I'd add more assets classes, including bonds and commodities.

I agree, there's no way the 'ER' is anything like 4-5% in today's environment. And just for plain leverage (no other bell and whistle on the strategy) S&P index futures are by far the most efficient way to leverage that index, and then as you say you can leverage there and not leverage other indices (small cap, foreign, etc) and still achieve a good deal of total leverage. Depends how much leverage you want. I don't want any net leverage, my stock allocation is well below 100%. But the implied financing rate on the futures now is ca. 0.4%, which beats any margin rate and by a lot if you're not contemplating quite large margin investments*. And there's no reason to use options *just* for leverage when there are futures. If you want to use options to modify your risk profile in the way only options can though, options on the S&P futures have lower bid-offers than options on the SPY ETF in general.

*Interactive Brokers is best AFAIK at currently 1.63% 0-100k, 1.13% 100k-1mil, 0.63% 1mil-3mil, 0.5% 3mil-200mil. Also the implied futures financing rate is considerably lower than the rate FDIC insured banks will borrow from *you*, so lending banks a large % of the principal in a ca. $104k investment in the SP (at perhaps 1%) and buying one ES futures contract, supported by a smaller % of the $104k as margin, is an arbitrage as compared to using the whole $104k to buy the SPY ETF. That's an unleveraged position though, net.

Rob Bertram
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Rob Bertram » Fri Dec 26, 2014 8:19 am

Yesterdaysnews wrote:I'm interested.
Okay, here are some relevant links from the thread I mentioned earlier.

Robert Shiller's Amazon review of the Ayres and Nalebuff book: http://www.amazon.com/Lifecycle-Investi ... B005X4I7ZI

Ayres and Nalebuff "mortgage your retirement"/lifecycle investing articles:
http://faculty.som.yale.edu/barrynalebu ... _v2008.pdf
http://www.bfjlaward.com/pdf/25881/73-8 ... M_0124.pdf

Reading list on leverage:
http://www.fsa.ulaval.ca/nfa2003/papier ... Wilson.pdf
http://papers.ssrn.com/sol3/papers.cfm? ... id=1687272
http://www.investmentreview.com/files/2 ... olios1.pdf
http://gosset.wharton.upenn.edu/research/retirement.pdf
http://papers.ssrn.com/sol3/papers.cfm? ... id=2239827

Using leveraged ETFs long-term:
http://www.etf.com/publications/journal ... funds.html
http://ddnum.com/articles/leveragedETFs.php
http://ieor.columbia.edu/files/seasieor ... v_2009.pdf
http://ieor.columbia.edu/files/seasieor ... v_2009.pdf
https://www.math.nyu.edu/faculty/avella ... 090515.pdf
http://seekingalpha.com/article/147312- ... -etfs-work
http://www.iijournals.com/doi/abs/10.39 ... 11.1.4.066
http://www.ibimapublishing.com/journals ... 715425.pdf
http://m.risk.net/digital_assets/1118/g ... h_2%29.pdf
http://www.iijournals.com/doi/abs/10.39 ... 13.3.4.023
http://www.cfapubs.org/doi/pdf/10.2469/dig.v39.n1.4


Pension funds using leverage: http://acrossthecurve.com/?p=15935

Expected returns: http://papers.ssrn.com/sol3/papers.cfm? ... id=2470935

Historic global returns: https://www.commonfund.org/ei/2012%20EI ... ER%204.pdf

Park
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Park » Fri Dec 26, 2014 9:03 am

https://www.questia.com/library/journal ... portfolios

Here's an addition to the readling list on leverage.



I edited to include the following.

There are 3 books that I would suggest:

Lifecycle Investing by Ian Ayres and Barry Nalebuff.

Are You A Stock Or A Bond? by Moshe Milevsky. One chapter "Debt Can Be Good At All Ages" is relevant.

Dispelling The Myths Of Borrowing To Invest by Talbot Stevens. The book isn't designed for Americans, but the principles are valid nevertheless.


Second edit includes the following link; what is relevant starts on page 40.

http://www.asac.ca/files/vol-24,-2003/Finance.pdf
Last edited by Park on Mon Dec 29, 2014 7:29 am, edited 2 times in total.

Rob Bertram
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Re: Anyone actually use leverage (ei ayres and nalebuff)?

Postby Rob Bertram » Fri Dec 26, 2014 9:11 am

freyj6 wrote:I guess I still have a lot to learn about the different options for doing this and how much they actually cost in different environments.

Maybe once I understand it better, I'll give it a shot if the market tanks 25 or 30 percent. But then of course, it could just keep going down.
There's a chance that the market will go up 100% before it drops 30%. I'm a firm believer that "time in" the market is a better strategy than "timing" the market.

freyj6 wrote:It does still seem to me that with the expense ratio and the inability to buy low and hold/buy through dips, you could get a similar risk and return by loading up on risky assets like small value, micro cap, emerging markets, etc.
If you leveraged a balanced portfolio of stocks and bonds, you could buy stocks during dips and sell when they are high. That's the common practice of rebalancing.

Now, there is a large practical difference between leveraging a total-market portfolio and tilting towards a factor or sector. You could underperform the market for years before you see that outperformance. Here's what Nisiprius says on that:
nisiprius wrote:
coachz wrote:But don't the history of these have higher average returns than total stock market index fund?
One of the oldest funds focussing on small-cap is the fund now known as DFA US Micro Cap Fund, DFSCX. When DFSCX came out, if you had invested $10,000 into it, and a friend had invested $10,000 into the Vanguard 500 Index Fund, then:

  • For the first four years, you'd have been ahead;
  • In 1985, your friend would have caught up.
  • Over a period of 18 years, 1985-2003, you'd have less than your friend.
  • The worst moment was in 6/30/1999, you'd have had $93,662, your friend would have had $188,114--your friend would have twice as much as you.
  • Finally, you would start to pull ahead.
  • Today, at the end of 32-1/2 years, you would be well ahead, $427,058 to your friend's $347,546.63.
  • This works out to an average of 0.63% more return per year.

Notice that
  • Yes, over this thirty year period, the micro-cap fund had higher average return than the S&P 500 fund.
  • But to get there, you had to wait through 18 years of underperformance.
  • How easy do you think it would be to stay the course through 18 years of underperformance, and seeing your friend's total return being twice yours?
  • And if you happened to need to draw on that fund any time during that 18 year period, you might not ever get back to even with your friend.

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