leverage and beating the market

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privatefarmer
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leverage and beating the market

Post by privatefarmer » Sat Jul 18, 2015 4:57 pm

I use leverage (through cheap margin via IB). I tilt to small/value. I understand the risks and the history of the different asset classes.

One thing I cannot wrap my mind around is why haven't professional money managers been able to beat the S/P 500 if all they had to do was use a little leverage and maybe tilt towards small/value? Why do we always hear that so few can beat even just the S/P 500 over long periods of time?? It seams that if it were that simple to take, say, just 1.25x leverage using cheap margin and tilt a little towards small/value that these professionals would do it successfully. I understand they'd be increasing their risk too, but nonetheless over long periods they should have beat the "market"...

Any answers?

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Phineas J. Whoopee
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Re: leverage and beating the market

Post by Phineas J. Whoopee » Sat Jul 18, 2015 6:59 pm

Based on those assumptions as I understand them, if we all did that then we could all beat the market.
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lack_ey
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Re: leverage and beating the market

Post by lack_ey » Sat Jul 18, 2015 7:05 pm

Leverage is not allowed for most equity funds and many institutional investors. And leverage when you're underperforming means underperforming by more and getting fired. And there were a sequence of years in the previous decade where for example 125% equities under reasonable rebalancing regimes would have done worse than 100% equities.

Small/value frequently underperform (and for a few/several years at a time, sometimes, long enough to ruin a career), and frequently managers are compared to a fair benchmark that's similarly tilted.

A lot of the 130/30 funds and so on (130% long, 30% short) underperformed and were shuttered. That said, that's more from the security selection and perhaps not getting the shorting right than the leverage itself.

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privatefarmer
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Re: leverage and beating the market

Post by privatefarmer » Sat Jul 18, 2015 7:30 pm

lack_ey wrote:Leverage is not allowed for most equity funds and many institutional investors. And leverage when you're underperforming means underperforming by more and getting fired. And there were a sequence of years in the previous decade where for example 125% equities under reasonable rebalancing regimes would have done worse than 100% equities.

Small/value frequently underperform (and for a few/several years at a time, sometimes, long enough to ruin a career), and frequently managers are compared to a fair benchmark that's similarly tilted.

A lot of the 130/30 funds and so on (130% long, 30% short) underperformed and were shuttered. That said, that's more from the security selection and perhaps not getting the shorting right than the leverage itself.
Thanks. Makes sense. And I do believe that part of Warren Buffet's success is due to the cheap leverage he has been able to obtain through his insurance companies. Plus the fact that he uses some sort of "value" calculation in choosing which companies to buy. So it seem's like us small investors can maybe gain a little extra bump through using a small amount of leverage coupled w/ a small/value tilt so long as we are able to stick with it for decades and deal w/ the volatility.

Hope I am right anyhow...

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JoMoney
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Re: leverage and beating the market

Post by JoMoney » Sat Jul 18, 2015 7:41 pm

One thing to keep in mind about leverage, is most people think about it terms of the result of a one time 'lump' of borrowing, as the market value changes, the ratio of of how much equity the buyer has also changes.
What I'm trying to get at, is that most people don't consider the effect of 're-balancing' the leverage. There needs to be more consideration given to the effect of maintaining a constant 50% (or whatever percent) leveraged position which would involve constant buying/selling to maintain. Leverage works great when everything is going up, but is disastrous when things go down. If one maintained a constant percentage, it would force you to sell even more during a downswing and the sequence of the returns could lead to disastrous results, ending with a balance that's too small to make any recovery. If instead of rebalancing the leverage you let it float, you could be allowing the portfolio to get closer and closer to the edge of a margin call.
If I put up $100 and borrowed $100 to buy $200 worth of stock I'd be levered 50%. If the market doubled that would be great, I'd have $400 worth of stock and owe $100 so I'd only be levered 25% at that point... but if along the way the market dropped in half I'd be in a position of owning $100 worth of stock and owing $100. If the borrowing was done on margin I'd likely have a margin-call and and be wiped out completely, if the borrowing was done through buying LEAPs or a home mortgage then I might be able to hold on to my 100%+ levered position, but I'd be in a more risky position then I signed up for initially, and I'd have a ticking time bomb as the LEAP approached its expiration or a mortgage due date approached.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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JoMoney
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Re: leverage and beating the market

Post by JoMoney » Sat Jul 18, 2015 7:45 pm

privatefarmer wrote:... I do believe that part of Warren Buffet's success is due to the cheap leverage he has been able to obtain through his insurance companies. Plus the fact that he uses some sort of "value" calculation in choosing which companies to buy...
Buffett has said that the float from insurance has provided them essentially cheap leverage. But when it comes to 'value' he has ridiculed the way it gets discussed and formulated in "growth" and "value" mutual funds.
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privatefarmer
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Re: leverage and beating the market

Post by privatefarmer » Sat Jul 18, 2015 8:06 pm

JoMoney wrote:One thing to keep in mind about leverage, is most people think about it terms of the result of a one time 'lump' of borrowing, as the market value changes, the ratio of of how much equity the buyer has also changes.
What I'm trying to get at, is that most people don't consider the effect of 're-balancing' the leverage. There needs to be more consideration given to the effect of maintaining a constant 50% (or whatever percent) leveraged position which would involve constant buying/selling to maintain. Leverage works great when everything is going up, but is disastrous when things go down. If one maintained a constant percentage, it would force you to sell even more during a downswing and the sequence of the returns could lead to disastrous results, ending with a balance that's too small to make any recovery. If instead of rebalancing the leverage you let it float, you could be allowing the portfolio to get closer and closer to the edge of a margin call.
If I put up $100 and borrowed $100 to buy $200 worth of stock I'd be levered 50%. If the market doubled that would be great, I'd have $400 worth of stock and owe $100 so I'd only be levered 25% at that point... but if along the way the market dropped in half I'd be in a position of owning $100 worth of stock and owing $100. If the borrowing was done on margin I'd likely have a margin-call and and be wiped out completely, if the borrowing was done through buying LEAPs or a home mortgage then I might be able to hold on to my 100%+ levered position, but I'd be in a more risky position then I signed up for initially, and I'd have a ticking time bomb as the LEAP approached its expiration or a mortgage due date approached.
Absolutely agree. I keep my leverage to a small enough amount that it, historically, would have never triggered a margin call.

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Re: leverage and beating the market

Post by lack_ey » Sat Jul 18, 2015 8:24 pm

privatefarmer wrote:
JoMoney wrote:One thing to keep in mind about leverage, is most people think about it terms of the result of a one time 'lump' of borrowing, as the market value changes, the ratio of of how much equity the buyer has also changes.
What I'm trying to get at, is that most people don't consider the effect of 're-balancing' the leverage. There needs to be more consideration given to the effect of maintaining a constant 50% (or whatever percent) leveraged position which would involve constant buying/selling to maintain. Leverage works great when everything is going up, but is disastrous when things go down. If one maintained a constant percentage, it would force you to sell even more during a downswing and the sequence of the returns could lead to disastrous results, ending with a balance that's too small to make any recovery. If instead of rebalancing the leverage you let it float, you could be allowing the portfolio to get closer and closer to the edge of a margin call.
If I put up $100 and borrowed $100 to buy $200 worth of stock I'd be levered 50%. If the market doubled that would be great, I'd have $400 worth of stock and owe $100 so I'd only be levered 25% at that point... but if along the way the market dropped in half I'd be in a position of owning $100 worth of stock and owing $100. If the borrowing was done on margin I'd likely have a margin-call and and be wiped out completely, if the borrowing was done through buying LEAPs or a home mortgage then I might be able to hold on to my 100%+ levered position, but I'd be in a more risky position then I signed up for initially, and I'd have a ticking time bomb as the LEAP approached its expiration or a mortgage due date approached.
Absolutely agree. I keep my leverage to a small enough amount that it, historically, would have never triggered a margin call.
Out of curiosity (since you've checked this?), what kind of margin calls were people seeing and margins needed during 1929-1932 to hold on?

Also, is it really fair to 'allow' leverage percentage to drift that much, even if it's technically possible to keep the positions open?

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Re: leverage and beating the market

Post by TJSI » Sat Jul 18, 2015 8:37 pm

privatefarmer,

I think part of the answer was contained in your question. Many professional money managers don't have a "long term" to produce results. They are often judged on yearly results and if it takes 10 years or more for a tilt to show its effect, than as lack_ey said "it can ruin a career"

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Re: leverage and beating the market

Post by alex_686 » Sat Jul 18, 2015 8:49 pm

privatefarmer wrote:One thing I cannot wrap my mind around is why haven't professional money managers been able to beat the S/P 500 if all they had to do was use a little leverage and maybe tilt towards small/value?
Yes they can. Look at hedge fund performance during the past 25 years during the great moderation. The problem with leverage is that the market has a skew. Often if has positive returns which margin can leverage. The random crash however wipes out those gains. Historically, leverage has not been a winning play. It is one of the reasons why funds report their Beta, which indicates leverage, and Alpha, which indicates performer management.

Side question, what are you basing your small/value tilt? It is my understanding that most of small / value premium has disappeared and that what is left is a small illiquidity premium.

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JoMoney
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Re: leverage and beating the market

Post by JoMoney » Sat Jul 18, 2015 8:50 pm

...I keep my leverage to a small enough amount that it, historically, would have never triggered a margin call.
Even if an event can't be found in the limited historical record we have doesn't mean it can't happen. History books might be helpful in guiding us from repeating our past mistakes (it would be wrong to believe the past can't be repeated), but they don't give us probabilities of the future, or allow us to compare the present to the past and assume the unique variables of our time (which may have never existed before) are comparable to the idiosyncrasies of the past.
John Maynard Keynes wrote:...Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols...
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Re: leverage and beating the market

Post by alex_686 » Sat Jul 18, 2015 9:15 pm

lack_ey wrote:A lot of the 130/30 funds and so on (130% long, 30% short) underperformed and were shuttered. That said, that's more from the security selection and perhaps not getting the shorting right than the leverage itself.
Technically speaking, a 130/30 fund would have a beta of 1 and should perform no differently than a unlevered fund. The cash raised by shorting the 30% of stocks is used to buy more long stocks. A 130/30 fund is a "double alpha" fund where you are paying for the portfolio manager alpha to select good stocks, the 130, and another alpha to short bad stocks, the 30.

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William Million
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Re: leverage and beating the market

Post by William Million » Sat Jul 18, 2015 9:45 pm

Assuming the small/value premium continues into the future, keep in mind that small/value can still under-perforrm for 10-15 year stretches After 5 years, most of us start to question the small/value premium.

After 10 years of under-performance, almost everyone has jumped ship. A manager who under-performs for that period of time will be out of a job.

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Re: leverage and beating the market

Post by Clive » Sun Jul 19, 2015 2:26 am

JoMoney wrote:
privatefarmer wrote:... I do believe that part of Warren Buffet's success is due to the cheap leverage he has been able to obtain through his insurance companies....
Buffett has said that the float from insurance has provided them essentially cheap leverage. ...
He has the insurance float, insurance premiums collected in lieu of claims later being paid out AND a massive amount of free loan from the taxman in the way of deferred taxes (something like $56B IIRC more recently). Being a major shareholder (or outright owning) also means that dividends are taxed less.

A wild guess, $100B of combined insurance float and deferred tax loans, costing 0%, so against recent $350B of Market Cap, 1.5 price to book value = $240B book value, plus the $100B free money makes around 40% leverage at zero cost. Stocks gain 12%, his leveraged equivalent gains 17%. Value gains 14%, he gains close to 20%.

Less of a competitive edge under more recent low interest rates as others can also borrow for next to nothing, but would have been great when interest rates (cost of borrowing) were much higher in the past.

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Re: leverage and beating the market

Post by packer16 » Sun Jul 19, 2015 1:29 pm

I think this is good idea for risk tolerant investors today. There are three caveats. First it must be used in moderation (debt/equity 20/80 to 33/67; 25% to 50% leverage - for every dollar of investments 25 cents to 50 cents of debt). Therefore, if market tanks by 50% your debt/equity is 50/50. Second, you must find a low-cost source of funds that will not have problems in crisis and call the loan, IB is probably the best I have heard of. Third, the strategy works best when the expected stock returns/borrowing rate is high. Now and since 2008 the last condition is probably true. Today Jack Bogle expects stock returns of 5 to 6% and the borrowing rates are closer to 2 to 2.5% from IB.

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Re: leverage and beating the market

Post by totallystudly » Sun Jul 19, 2015 2:26 pm

IB Borrowing rates are less than that. They are around 1-1.5% depending on how much you borrow. I think we are at a generational low, the opposite of when my parents talked about double digit mortgages in the late 70's and early 80's and CD's paying 10% and so forth.

I think you are missing out if you look at taking advantage of these historically low interest rates via borrowing. I prefer to do it by investing in dividend producing closed end funds and stocks, borrow at 1%, reinvest at 6-7% and pay down the borrowings as fast as possible while maintaining some hedge on the overall portfolio.

Closed end funds frequently use leverage and can get it at preferential rates better than most investors, so that is a way to get the effect of leverage without the call risk.

The key is managing the downside risk and hedging, which most people don't do or talk about much.

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Re: leverage and beating the market

Post by bertilak » Sun Jul 19, 2015 2:31 pm

When leverage is involved the beating can go either way.
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Re: leverage and beating the market

Post by Rysto » Sun Jul 19, 2015 2:35 pm

Don't forget that equity funds tend to see large outflows during market downturns. It seems to me that could be disastrous if a levered fund had to try to unwind their positions at that time.

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Re: leverage and beating the market

Post by Johno » Sun Jul 19, 2015 2:47 pm

In a recent discussion of 'Kelly Criterion' I showed that no leverage at all performed best Dec 2000-Dec 2014, for the S&P, even in a period of an overall rising market. Theoretical KC can come out in the mid 100%'s depending on assumptions to put in the equations, 140% was quoted on that thread. For mid 1980's to recently the highest return was at 190% S&P. Again, this S&P total return not other types of more specialized stock assets and the assumed cost of leverage was LIBOR+25, quarterly rebalance, a proxy for the implicit financing rate of holding and rolling over S&P index futures. Interactive Brokers margin rates while best in the market for individuals are Fed Funds+>100, so significantly more expensive than the financing implicit in index futures, but index futures don't cover eg. small value stocks.

I would anyway somewhat challenge the statement that active managers don't use leverage. As noted there are regulatory restrictions in using 'conventional' leverage in mutual funds. But OTOH lots of Closed End Funds use leverage, generally by issuing short term commercial paper like instruments in the money market for up to around 30% (typically) of fund gross assets. Of course this structure had problems in the immediate post-Lehman credit crunch and funds have modified it somewhat since, but still funds like this react not only in to their asset prices (magnified by leverage) and perceived prospects for riskless short term rates but some risk of not being able to fund at all in a crisis.

Then of course there are also numerous leveraged passive ETF's now, which use futures and total return swaps generally to generate that leverage, rather than conventional explicit borrowing.

Back to DIY methods, there would seem some extra risk also in the fact that IB is such a better deal than everyone else (who caters at all to retail investors). Besides much better rate on margin borrowing, they also allow the calculation of allowable borrowing on a 'portfolio margin' basis which seems to come out around 75% of stock assets. That means 25% borrowing say is even safer than it would be under a conventional Reg T 50% borrowing limit. However, IB could change their policy. For example till recently IB was also good (though not way better than everybody else) on futures margin in IRA's, requiring just exchange minimum. Then suddenly they decided (apparently at the 'suggestion' of their regulator) to triple that requirement. I therefore moved my IRA futures trading to TD-Ameritrade which uses slightly higher than exchange minimum. I still have a taxable account at IB, ETF's, which I view as a source of back up liquidity. Though I don't use net leverage in financial assets, I might use short term margin borrowing for bridge loans to my real estate entity while 'it' seeks permanent non-recourse financing of properties. That would facilitate eg not liquidating bond funds with embedded cg's. But I wouldn't put myself in a situation where I was SOL liquidity-wise if IB suddenly changed their margin policy.

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Re: leverage and beating the market

Post by packer16 » Sun Jul 19, 2015 2:57 pm

Johno wrote:In a recent discussion of 'Kelly Criterion' I showed that no leverage at all performed best Dec 2000-Dec 2014, for the S&P, even in a period of an overall rising market. Theoretical KC can come out in the mid 100%'s depending on assumptions to put in the equations, 140% was quoted on that thread. For mid 1980's to recently the highest return was at 190% S&P. Again, this S&P total return not other types of more specialized stock assets and the assumed cost of leverage was LIBOR+25, quarterly rebalance, a proxy for the implicit financing rate of holding and rolling over S&P index futures. Interactive Brokers margin rates while best in the market for individuals are Fed Funds+>100, so significantly more expensive than the financing implicit in index futures, but index futures don't cover eg. small value stocks.

I would anyway somewhat challenge the statement that active managers don't use leverage. As noted there are regulatory restrictions in using 'conventional' leverage in mutual funds. But OTOH lots of Closed End Funds use leverage, generally by issuing short term commercial paper like instruments in the money market for up to around 30% (typically) of fund gross assets. Of course this structure had problems in the immediate post-Lehman credit crunch and funds have modified it somewhat since, but still funds like this react not only in to their asset prices (magnified by leverage) and perceived prospects for riskless short term rates but some risk of not being able to fund at all in a crisis.

Then of course there are also numerous leveraged passive ETF's now, which use futures and total return swaps generally to generate that leverage, rather than conventional explicit borrowing.

Back to DIY methods, there would seem some extra risk also in the fact that IB is such a better deal than everyone else (who caters at all to retail investors). Besides much better rate on margin borrowing, they also allow the calculation of allowable borrowing on a 'portfolio margin' basis which seems to come out around 75% of stock assets. That means 25% borrowing say is even safer than it would be under a conventional Reg T 50% borrowing limit. However, IB could change their policy. For example till recently IB was also good (though not way better than everybody else) on futures margin in IRA's, requiring just exchange minimum. Then suddenly they decided (apparently at the 'suggestion' of their regulator) to triple that requirement. I therefore moved my IRA futures trading to TD-Ameritrade which uses slightly higher than exchange minimum. I still have a taxable account at IB, ETF's, which I view as a source of back up liquidity. Though I don't use net leverage in financial assets, I might use short term margin borrowing for bridge loans to my real estate entity while 'it' seeks permanent non-recourse financing of properties. That would facilitate eg not liquidating bond funds with embedded cg's. But I wouldn't put myself in a situation where I was SOL liquidity-wise if IB suddenly changed their margin policy.
I would be interested to see if your results changed significantly after 2008. Before that time interest rates and ERP were much closer together (resulting in as you say marginally better or worse results), however, after 2008 the gap has widened significantly and stayed there. So unless interest rates or stock prices skyrocket in the next few years, this situation is likely to continue.

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Re: leverage and beating the market

Post by Maynard F. Speer » Sun Jul 19, 2015 3:17 pm

SPXL 3x ETF

Just wondering what about 1/3rd 3x leveraged ETF; 2/3rds cash ... Market return with a maximum possible drawdown of 33%?

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Re: leverage and beating the market

Post by JoMoney » Sun Jul 19, 2015 3:39 pm

We can see the results of leveraged ETF's (i.e. SPXL 3x S&P500) since 2008)
MStar Link
The results look impressive, but there is a danger lurking with a 'rebalanced' proportional amount of leverage that I was trying to point out above.
In a volatile market that includes several steep downswings it could crush a portfolio that regularly rebalances the leverage. While it may avoid a situation where the portfolio has a 'margin call' it could lead to the balance being reduced to such a small amount that there is no hope of recovery.
I have linked this paper before, I think it does a good job illustrating the problem.
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http://www.cfapubs.org/doi/pdf/10.2469/cp.v2004.n2.3379
...the leveraged portfolio performs dismally. Why? Although it does have the highest monthly expected return, it has such high variability that the likelihood of losing a substantial proportion of capital is so high that it likely will cause the investor to rebuild from a low base and never really recoup losses...
While the potential returns can look impressive, leverage adds additional risks that I just don't think are necessary... but I suppose people can have different tastes for different types of risk.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: leverage and beating the market

Post by packer16 » Sun Jul 19, 2015 4:07 pm

I think one reason for an individual margin account is that you can control the rebalancing. In the calculations I have performed I only rebalanced to higher debt ratios (starting from modest debt ratios) and never rebalanced the debt down. The only reason the debt % goes down is the asset appreciated and the debt level remained the same.

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Re: leverage and beating the market

Post by Phineas J. Whoopee » Sun Jul 19, 2015 4:09 pm

Leveraged funds work differently than an investor using leverage to buy or short assets. The leveraged funds are only trying to deliver day-by-day results. They're very clear in saying (see the linked article) that they are not appropriate for investment periods longer than one trading day: in after open; out before close. They're strictly for day traders who know what they're doing.

The funds do not work as one might naïvely think they will based on the name alone with no further analysis.

I understand some skepticism of the pronouncements of hedge funds and the like, but I don't understand the skepticism when they're clearly saying the financial equivalent of Go around! Do not land at this airport! Go around or you will crash!

PJW

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Re: leverage and beating the market

Post by Johno » Sun Jul 19, 2015 5:29 pm

packer16 wrote:
Johno wrote:In a recent discussion of 'Kelly Criterion' I showed that no leverage at all performed best Dec 2000-Dec 2014, for the S&P, even in a period of an overall rising market. Theoretical KC can come out in the mid 100%'s depending on assumptions to put in the equations, 140% was quoted on that thread. For mid 1980's to recently the highest return was at 190% S&P. Again, this S&P total return not other types of more specialized stock assets and the assumed cost of leverage was LIBOR+25, quarterly rebalance, a proxy for the implicit financing rate of holding and rolling over S&P index futures.
I would be interested to see if your results changed significantly after 2008. Before that time interest rates and ERP were much closer together (resulting in as you say marginally better or worse results), however, after 2008 the gap has widened significantly and stayed there. So unless interest rates or stock prices skyrocket in the next few years, this situation is likely to continue.
I guess depends what you mean by ERP (equity risk premium). Stocks have had great realized returns since around 2008 (late 2008 or early 2009 particularly, obviously) with only relatively narrow set backs. And of course (regularly rebalanced) high leverage works great when the market is almost always going up, so of course the leverage for max return would have been much higher Dec 2008-Dec 2014 (274%). The problem needless to say is predicting the future leverage for max return. And starting from today I'd distinguish short term rates, which are factually known to be low and can be locked in at relatively low values for the medium term future, as opposed to an equity risk premium which isn't directly visible and partly a matter of opinion. And the choppiness of stock returns is also very important, so big up move with hardly any significant corrections is a key factor in such high max return leverage ratio in 2008-'14. I don't know how one could determine whether that was likely or not to continue.

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Re: leverage and beating the market

Post by Johno » Sun Jul 19, 2015 6:16 pm

Phineas J. Whoopee wrote:Leveraged funds work differently than an investor using leverage to buy or short assets. The leveraged funds are only trying to deliver day-by-day results. They're very clear in saying (see the linked article) that they are not appropriate for investment periods longer than one trading day: in after open; out before close. They're strictly for day traders who know what they're doing.

The funds do not work as one might naïvely think they will based on the name alone with no further analysis.

I understand some skepticism of the pronouncements of hedge funds and the like, but I don't understand the skepticism when they're clearly saying the financial equivalent of Go around! Do not land at this airport! Go around or you will crash!
Those funds work exactly the same way as the results I mentioned I calculated, leverage that's rebalanced periodically to the starting level in % terms. Except they do it daily rather than quarterly. They don't particularly 'seek' to do it daily. It's just that if they didn't do it daily, the leverage wouldn't always be 2 or 3 or whatever and the new investors would have to first look up what the leverage was today, 2.15, 2.78 etc., even less transparent and even more complicated to use. Also they may have regulatory approval for only a certain max.

As to the wording, anyone relying on legal disclaimers to quantitatively evaluate an investment shouldn't even be looking at that investment, so the bottom line would be the same: don't. However in a serious discussion of how those funds or leverage actually work, 'only suitable for someone with a one day horizon' is a ridiculous statement, approved legalese disclaimer or not. One day is just the only period over which the investment will act like the classic CAPM graph where more leverage means more return. After that, it depends on the actual process of daily movements, and more risk can mean *less* return above a certain point. Again per the results I gave above, 1986-2014 max return on the S&P was at 190% (so below even a 2 times ETF) financing at futures-like financing rate, and it would't change dramatically if you shortened the rebalance interval to daily from quarterly. Leveraged ETF's finance at similar rates to what I assumed, though they also charge investors significant expense ratio in addition.

As to not rebalancing to a constant % leverage, stated that way it presents an infinite number of possibilities. There's no way to evaluate a leverage strategy without specifying what it is. Periodic rebalance to a fixed % leverage, ie an equity allocation more than 100%, is a direct extension of the common convention of assuming investors would rebalance to a fixed % of equities less than 100%. Nobody has to do either, it's just a common convention for comparison, and there's no first order reason to think there's an alternative simple rule which always works better.

Key point: high leverage often eventually under performs, intrinsically, not because of anything sinister about leveraged ETF daily rebalancing.

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Re: leverage and beating the market

Post by Yesterdaysnews » Sun Jul 19, 2015 6:23 pm

Some leverage makes sense when one is after absolute returns. Leveraging a carry trade position for example to obtain desired absolute return.

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Phineas J. Whoopee
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Re: leverage and beating the market

Post by Phineas J. Whoopee » Sun Jul 19, 2015 6:30 pm

^^ For example:
Direxion Investments wrote:...
The Direxion Daily S&P 500 Bull & Bear 3x Shares seeks daily investment results, before fees and expenses, of 300% or 300% of the inverse (or opposite) of the performance of the S&P 500 Index. There is no guarantee the funds will meet their stated investment objectives.

These leveraged ETFs seek a return that is +300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark’s cumulative return for periods greater than a day.
...
[Emphasis original]

You invest, or whatever you call it, in whatever you like, Johno.

Everybody else: Do not buy a leveraged or inverse fund unless you're a day trader, have an investment horizon of less than one day, and very severely know what you're doing.

Johno, if you want, you can have the last word in this our little mini-exchange in this thread. I won't respond. I also won't express untruths.

PJW

Tanelorn
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Re: leverage and beating the market

Post by Tanelorn » Sun Jul 19, 2015 7:55 pm

bertilak wrote:When leverage is involved the beating can go either way.
Lol, good one!

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Re: leverage and beating the market

Post by Park » Sun Jul 19, 2015 11:09 pm

JoMoney wrote:One thing to keep in mind about leverage, is most people think about it terms of the result of a one time 'lump' of borrowing, as the market value changes, the ratio of of how much equity the buyer has also changes.
What I'm trying to get at, is that most people don't consider the effect of 're-balancing' the leverage. There needs to be more consideration given to the effect of maintaining a constant 50% (or whatever percent) leveraged position which would involve constant buying/selling to maintain. Leverage works great when everything is going up, but is disastrous when things go down. If one maintained a constant percentage, it would force you to sell even more during a downswing and the sequence of the returns could lead to disastrous results, ending with a balance that's too small to make any recovery. If instead of rebalancing the leverage you let it float, you could be allowing the portfolio to get closer and closer to the edge of a margin call.
If I put up $100 and borrowed $100 to buy $200 worth of stock I'd be levered 50%. If the market doubled that would be great, I'd have $400 worth of stock and owe $100 so I'd only be levered 25% at that point... but if along the way the market dropped in half I'd be in a position of owning $100 worth of stock and owing $100. If the borrowing was done on margin I'd likely have a margin-call and and be wiped out completely, if the borrowing was done through buying LEAPs or a home mortgage then I might be able to hold on to my 100%+ levered position, but I'd be in a more risky position then I signed up for initially, and I'd have a ticking time bomb as the LEAP approached its expiration or a mortgage due date approached.
In Lifecycle Investing by Ayres and Nalebuff, they looked at how a portfolio with a constant leverage ratio of 200% (assets to equity) did; portfolio was rebalanced monthly. In the long run, it outperformed without a margin call. I am NOT advocating 200% leverage. FWIW, I use leverage, but am not levering the US stock market.
Last edited by Park on Sun Jul 19, 2015 11:14 pm, edited 1 time in total.

Park
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Re: leverage and beating the market

Post by Park » Sun Jul 19, 2015 11:13 pm

Phineas J. Whoopee wrote:^^ For example:
Direxion Investments wrote:...
The Direxion Daily S&P 500 Bull & Bear 3x Shares seeks daily investment results, before fees and expenses, of 300% or 300% of the inverse (or opposite) of the performance of the S&P 500 Index. There is no guarantee the funds will meet their stated investment objectives.

These leveraged ETFs seek a return that is +300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark’s cumulative return for periods greater than a day.
...
[Emphasis original]

You invest, or whatever you call it, in whatever you like, Johno.

Everybody else: Do not buy a leveraged or inverse fund unless you're a day trader, have an investment horizon of less than one day, and very severely know what you're doing.

Johno, if you want, you can have the last word in this our little mini-exchange in this thread. I won't respond. I also won't express untruths.

PJW
http://www.etf.com/publications/journal ... nopaging=1

I would feel very comfortable holding a 2X S&P500 ETF for 30 days; please see the above article.

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JoMoney
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Re: leverage and beating the market

Post by JoMoney » Mon Jul 20, 2015 6:54 am

Warren Buffett wrote:I've seen more people fail because of liquor and leverage -- leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing.

People succeed in life countless different ways but failures group around a few key themes. As such, you learn more from people's failures than people's successes.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Johno
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Re: leverage and beating the market

Post by Johno » Mon Jul 20, 2015 9:21 am

JoMoney wrote:
Warren Buffett wrote:I've seen more people fail because of liquor and leverage -- leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing.

People succeed in life countless different ways but failures group around a few key themes. As such, you learn more from people's failures than people's successes.
When the simplistic, hypocritical* Buffett quotes are rolled out, you know the discussion has turned non serious, at least for the moment. :D

Non serious discussion as in 'leverage is good' (which as typically, nobody actually categorically said) v 'leverage is bad' (which some simplistic posts do seem to say).

The serious issue IMO is determining the multi-period real world expected return on leveraged stock positions. In the classic CAPM one period graph, more leverage just means more risk and more return in proportion to infinity. In a real world multi-period case with rebalancing to a given leverage ratio, which is necessary in some form eventually, there's typically a point beyond which return starts decreasing with more leverage though risk keeps increasing. The potential issue for leveraged ETF's in particular is that that point seems to have often been less than 200% equity position historically even before considering expense ratio. OTOH nobody ever said a 2-3 levered ETF had to be the *entire* portfolio, even a 3x fund can be used as a tool to maintain 101% equity position if so desired. And if 100% equity isn't ruled out as a rash position (though I've been 100% stocks and never would be, and many people claiming to be aren't really) on what basic principal is 101% ruled out? Let's recall the OP mentioned 125%, not 300%.

*his companies don't have 100% equity balance sheets, ie they use leverage. Then again he's not the one speaking in this thread, as he never is when invoked on this forum.

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Re: leverage and beating the market

Post by Park » Mon Jul 20, 2015 9:56 am

JoMoney wrote:
Warren Buffett wrote:I've seen more people fail because of liquor and leverage -- leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing.

People succeed in life countless different ways but failures group around a few key themes. As such, you learn more from people's failures than people's successes.
If you do an internet search, you'll find a paper which found that WB's leverage ratio is 160% (assets to equity). I think Warren Buffett says what he says, because he realizes that if members of the general public do what he does, some of them will be gravely hurt financially.

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Re: leverage and beating the market

Post by KyleAAA » Mon Jul 20, 2015 10:22 am

The term "beat the market" is meaningless in this context. What matters is risk-adjusted returns. The S&P 500 wouldn't be an appropriate benchmark, so you wouldn't necessarily "beat the market" in this case. You might. Unless 2008 happens again.

How much do you pay for your leverage from IB and which ETFs do you use? It's not a horrible plan, but it's definitely risky.

Day9
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Re: leverage and beating the market

Post by Day9 » Mon Jul 20, 2015 4:12 pm

Two all time Boglehead classics:

A Different Approach to Asset Allocation (by Market Timer)

Market Timer's Margin Call

A more recent thread:

Should I use margin to buy a balanced fund (by Rob Bertram)

While IB margin rates are low, the implied financing on future contracts is even lower, about 0.5%.

Look at investments in the context of a portfolio, not in isolation (many Bogleheads fail here).

I've found that a leveraged diversified portfolio can have higher expected return with lower risk than a 100% stock portfolio. But if a 60/40 portfolio already matches your risk tolerance then there is no need to use leverage.

There is a technique where you buy futures contracts at ~0.5% implied financing and stick your collateral in CDs with favorable early withdrawal terms. This might be an arbitrage opportunity to boost returns 1% or more. But that is before tax so run the numbers for your own situation.
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ShiftF5
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Re: leverage and beating the market

Post by ShiftF5 » Mon Jul 20, 2015 8:12 pm

In my younger years I tried to get cute with several different strategies and found in many cases it works until it doesn't.

The potential upside was attractive but I grew less and less willing to risk the potential ugly downside.

Warren Buffet says:

Rule #1. Don't Lose Money.

Rule #2. When in Doubt, Reread Rule #1.

That has saved me several times when I've been tempted.

Best wishes.

Park
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Re: leverage and beating the market

Post by Park » Tue Jul 21, 2015 7:02 am

ShiftF5 wrote:In my younger years I tried to get cute with several different strategies and found in many cases it works until it doesn't.

The potential upside was attractive but I grew less and less willing to risk the potential ugly downside.

Warren Buffet says:

Rule #1. Don't Lose Money.

Rule #2. When in Doubt, Reread Rule #1.

That has saved me several times when I've been tempted.

Best wishes.
Berkshire Hathaway lost 37% in 1987, 37% in 1989-1990, 49% 1998-2000, 51% in 2007-2009

Nathan Drake
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Re: leverage and beating the market

Post by Nathan Drake » Sat Jan 14, 2017 11:05 pm

If you're a buy & hold investor that has been able to weather downturns before in the past and doesn't have a need to touch investments for 30+ years, is there any issue in holding a bit of leverage to increase returns and avoid margin calls? In my early 30s and would like to find a smart way to do this if I'm able to handle the volatility (which I think I am), but I don't want to run into the issue "market_timer" faced where he was wiped out completely.

I'm not as knowledgeable as others here on leverage, but why can't I get a loan at a low interest rate that I can simply pay back over time? Even if my investments lost 90% of their value, I'd still pay off the loan with earnings from my job. I just want to avoid any chance of margin calls but be able to use a bit of leverage intelligently to amplify returns like you're able to do in real estate, but without the downsides of real estate (tenants, lack of diversification, high transaction costs, etc).

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Re: leverage and beating the market

Post by Jags4186 » Sat Jan 14, 2017 11:26 pm

Nathan Drake wrote:If you're a buy & hold investor that has been able to weather downturns before in the past and doesn't have a need to touch investments for 30+ years, is there any issue in holding a bit of leverage to increase returns and avoid margin calls? In my early 30s and would like to find a smart way to do this if I'm able to handle the volatility (which I think I am), but I don't want to run into the issue "market_timer" faced where he was wiped out completely.

I'm not as knowledgeable as others here on leverage, but why can't I get a loan at a low interest rate that I can simply pay back over time? Even if my investments lost 90% of their value, I'd still pay off the loan with earnings from my job. I just want to avoid any chance of margin calls but be able to use a bit of leverage intelligently to amplify returns like you're able to do in real estate, but without the downsides of real estate (tenants, lack of diversification, high transaction costs, etc).
I'll just leave this here...viewtopic.php?f=10&t=5934

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privatefarmer
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Re: leverage and beating the market

Post by privatefarmer » Sun Jan 15, 2017 2:16 am

Nathan Drake wrote:If you're a buy & hold investor that has been able to weather downturns before in the past and doesn't have a need to touch investments for 30+ years, is there any issue in holding a bit of leverage to increase returns and avoid margin calls? In my early 30s and would like to find a smart way to do this if I'm able to handle the volatility (which I think I am), but I don't want to run into the issue "market_timer" faced where he was wiped out completely.

I'm not as knowledgeable as others here on leverage, but why can't I get a loan at a low interest rate that I can simply pay back over time? Even if my investments lost 90% of their value, I'd still pay off the loan with earnings from my job. I just want to avoid any chance of margin calls but be able to use a bit of leverage intelligently to amplify returns like you're able to do in real estate, but without the downsides of real estate (tenants, lack of diversification, high transaction costs, etc).
in similar situation as you. If you're starting out, have a good career and high probability of earning a lot over the next 30-40 years, I think it is very reasonable and probably smart to use CHEAP leverage (ie through interactive brokers) in a CONTROLLED manner as a buy-and-holder. I still throw everything I can into retirement accounts, and do not leverage those. however, in my considerably smaller taxable account I use leverage w/ IB. I have calculated how much leverage I can have and not have a margin call even w/ a 40% drop. I figure this will eliminate all but the worst market crashes. Using portfolio margin w/ IB one can have a significant amount of leverage and withstand a 40% drop (I am able to borrow $1 for every dollar I have invested w/ them) bc portfolio margin has much wider parameters on when a margin call would occur than Reg T Margin. And the interest rate (although it is variable) is currently 1.9%. It's a no-brainer to me.

Now, will this alter your financial course? No. If you are maxing out your retirement accounts, if you own a home, if you have a good paying job, etc etc using a controlled amount of leverage on your smaller taxable account is probably not going to change when you'll retire or substantially change your finances. But it's still hopefully a nice added boost to your returns.

I calculate what my employment income would equate to as an investment, if I were using the 4% SWD, then I throw in the value of my home and my retirement accounts and I realize that my taxable account is a drop in the bucket. So leveraging it statistically should improve it's returns but if I get burned its not a large part of my overall net worth.

The key is that you see it as buy-and-hold. If you are borrowing to invest you had better be able to keep the money invested for at least 10 years, hopefully much longer. The only lender that I have found that can do this at decent rates is interactive brokers, and that may change in the future. It is possible that they'll increase their fees to borrow and you'll be forced to sell your positions.

It's like anything else : it's naiive to just say "don't use leverage" and its naiive to say "max out your leverage". moderation is the key. successful businesses use leverage/debt to increase their profits and grow their business faster. This is no different. As long as you have crunched the numbers and understand what your potential drawdowns will be, I think it's a smart choice. I think the fact that you are posting on bogleheads shows that you know a thing or two about investing and would not freak out as much as the typical investor when the market falls by 40%.

Also, one last comment, even if we have another huge market crash, say 60% drawdown, being forced into a margin call does not mean your account is "wiped out". They would only sell enough stock to get you back into compliance w/ their margin parameters, so it would only be a part of your portfolio not the entire thing.

Clive
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Re: leverage and beating the market

Post by Clive » Sun Jan 15, 2017 6:47 am

Maynard F. Speer wrote:SPXL 3x ETF

Just wondering what about 1/3rd 3x leveraged ETF; 2/3rds cash ... Market return with a maximum possible drawdown of 33%?

Image
Market return tracking it tighter if you rebalance relatively frequently such as quarterly
Image
https://www.portfoliovisualizer.com/bac ... n2_1=66.67

Which means that the 33% drawdown is only for the duration between rebalance points.

Rather than rebalancing at fixed time intervals you might rebalance at band trigger levels, in which case the 'drawdown reduction' can vanish and you end up with the (near) exact same as the market risk for (near) exact same reward.

LETF's are useful for liquidity. If your target stock exposure is 60%, has fallen to 50% but to top up that would mean having to early close a (generally higher yielding) fixed term bond (with a penalty) to do so, then instead selling $1 of 1x stock to buy $1 of 2x stock (LETF) ... scaled to however many $'s required to realign to desired levels of stock exposure, has you back at target stock weightings without having had to sell any bonds. Later when bonds do mature (without penalty) you might sell the 2x holdings and rebalance back to purer 1x stock and bond holdings.

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Re: leverage and beating the market

Post by Clive » Sun Jan 15, 2017 7:02 am

Zvi Bodie likes 10/90. 90% in TIPS, 10% in 10x (he likes LEAPS/Options for that and loads into the equivalent of 10x leveraged stock exposure). Between trades the downside is <10% i.e. all of the Options value lost, less any gains the TIPS make. Personally I use 5x equivalents myself such as short volatility. As you scale up leverage, so you also need to scale up rebalance frequency. 2x and you get away with yearly rebalancing, 3x and perhaps 6 monthly rebalancing ... etc. Such that the rebalancing voids the drawdown 'protection' as you will at some times repeatedly rebalance from bonds to leveraged stock across a sequential sequence series of rebalance events.

Some Investment Trusts in the UK run with terms such as being able to shift anywhere between say 80% to 120% stock as they deem fit at any one time. Typically they can relatively outperform the market, but after costs, taxes and (typically relatively high) fees, serve no better than non-leveraged i.e. the leverage/timing benefits the outfit/managers, not the investor.

lgs88
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Re: leverage and beating the market

Post by lgs88 » Sun Jan 15, 2017 7:03 am

Park wrote:
ShiftF5 wrote:In my younger years I tried to get cute with several different strategies and found in many cases it works until it doesn't.

The potential upside was attractive but I grew less and less willing to risk the potential ugly downside.

Warren Buffet says:

Rule #1. Don't Lose Money.

Rule #2. When in Doubt, Reread Rule #1.

That has saved me several times when I've been tempted.

Best wishes.
Berkshire Hathaway lost 37% in 1987, 37% in 1989-1990, 49% 1998-2000, 51% in 2007-2009
Berkshire Hathaway's share price might have fallen by that much, but their superb liquidity allowed them to snap up preferred shares of fantastic businesses -- Dow Chemical, Goldman Sachs, BoFA -- on highly advantageous terms.
merely an interested amateur

Valuethinker
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Re: leverage and beating the market

Post by Valuethinker » Sun Jan 15, 2017 8:44 am

JoMoney wrote:
privatefarmer wrote:... I do believe that part of Warren Buffet's success is due to the cheap leverage he has been able to obtain through his insurance companies. Plus the fact that he uses some sort of "value" calculation in choosing which companies to buy...
Buffett has said that the float from insurance has provided them essentially cheap leverage. But when it comes to 'value' he has ridiculed the way it gets discussed and formulated in "growth" and "value" mutual funds.
"Price is what you pay, value is what you buy"

Buffett doesn't buy things which are "cheap" which is the classic Fama-French value stock (bottom decile Price to Book). Instead he buys "good businesses" that have a "wide moat" ie natural barriers to competition. But he waits until the prices are attractive, as he did with Goldman Sachs and GE (money, convertible into equity, lent at 10% at the bottom of the crash).

That aerospace component supplier is another. As he says once they get a part specified for a plane, they will be selling that part for another 30 years while that plane is still flying (the last 747 is being/ has been built; no doubt a 747 will still be flying, somewhere, in 40 years).

He is now also buying businesses that require large amounts of capital investment, but where the return on that is semi guaranteed (by regulation or barriers to entry): electric utilities (regulated ones) and railways.

That's where his leverage comes in. The insurance "float" gives him the extremely cheap capital to borrow at say 3%, invest at 6-9% and if you do that you have bought into a money machine.

Nathan Drake
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Re: leverage and beating the market

Post by Nathan Drake » Sun Jan 15, 2017 8:21 pm

privatefarmer wrote:
Nathan Drake wrote:If you're a buy & hold investor that has been able to weather downturns before in the past and doesn't have a need to touch investments for 30+ years, is there any issue in holding a bit of leverage to increase returns and avoid margin calls? In my early 30s and would like to find a smart way to do this if I'm able to handle the volatility (which I think I am), but I don't want to run into the issue "market_timer" faced where he was wiped out completely.

I'm not as knowledgeable as others here on leverage, but why can't I get a loan at a low interest rate that I can simply pay back over time? Even if my investments lost 90% of their value, I'd still pay off the loan with earnings from my job. I just want to avoid any chance of margin calls but be able to use a bit of leverage intelligently to amplify returns like you're able to do in real estate, but without the downsides of real estate (tenants, lack of diversification, high transaction costs, etc).
in similar situation as you. If you're starting out, have a good career and high probability of earning a lot over the next 30-40 years, I think it is very reasonable and probably smart to use CHEAP leverage (ie through interactive brokers) in a CONTROLLED manner as a buy-and-holder. I still throw everything I can into retirement accounts, and do not leverage those. however, in my considerably smaller taxable account I use leverage w/ IB. I have calculated how much leverage I can have and not have a margin call even w/ a 40% drop. I figure this will eliminate all but the worst market crashes. Using portfolio margin w/ IB one can have a significant amount of leverage and withstand a 40% drop (I am able to borrow $1 for every dollar I have invested w/ them) bc portfolio margin has much wider parameters on when a margin call would occur than Reg T Margin. And the interest rate (although it is variable) is currently 1.9%. It's a no-brainer to me.

Now, will this alter your financial course? No. If you are maxing out your retirement accounts, if you own a home, if you have a good paying job, etc etc using a controlled amount of leverage on your smaller taxable account is probably not going to change when you'll retire or substantially change your finances. But it's still hopefully a nice added boost to your returns.

I calculate what my employment income would equate to as an investment, if I were using the 4% SWD, then I throw in the value of my home and my retirement accounts and I realize that my taxable account is a drop in the bucket. So leveraging it statistically should improve it's returns but if I get burned its not a large part of my overall net worth.

The key is that you see it as buy-and-hold. If you are borrowing to invest you had better be able to keep the money invested for at least 10 years, hopefully much longer. The only lender that I have found that can do this at decent rates is interactive brokers, and that may change in the future. It is possible that they'll increase their fees to borrow and you'll be forced to sell your positions.

It's like anything else : it's naiive to just say "don't use leverage" and its naiive to say "max out your leverage". moderation is the key. successful businesses use leverage/debt to increase their profits and grow their business faster. This is no different. As long as you have crunched the numbers and understand what your potential drawdowns will be, I think it's a smart choice. I think the fact that you are posting on bogleheads shows that you know a thing or two about investing and would not freak out as much as the typical investor when the market falls by 40%.

Also, one last comment, even if we have another huge market crash, say 60% drawdown, being forced into a margin call does not mean your account is "wiped out". They would only sell enough stock to get you back into compliance w/ their margin parameters, so it would only be a part of your portfolio not the entire thing.
Thanks, can you lay out your strategy with this?

Let's use an example:

Say one earns 100K, has portfolio of 200K tax advantaged accounts and 300K taxable accounts split (500K total), and are able to save around 20-25K per year in taxable accounts (1500-2000 per month) in addition to maxing out all other tax sheltered accounts (18K + employer match, 5.5K Roth, and ~3.35K HSA).

Allocation is approximately 60% international stocks and 40% US stocks

How would you structure a relatively safe amount of leverage? How does your interest rate with interactive brokers work? -- you mention that it's variable, which I'd be concerned with in a rising interest rate environment. Is there any way to get a fixed rate and lock in fees?

Those are the big risks to me that stand out which would perhaps not make it worth the hassle.

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