Levering a portfolio to a 60/40 equivalent

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birdec
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Levering a portfolio to a 60/40 equivalent

Post by birdec » Thu Jun 28, 2018 4:53 pm

What are your thoughts on levering a portfolio up to the equivalent of either a) the volatility of a 60/40 portfolio or b) the max drawdown of a 60/40 portfolio?

Portfolio 1 is 60% stocks (VFINX), 40% bonds (VBMFX)
Portfolio 2 is 50% stocks, 150% bonds --> same volatility as 60/40
Portfolio 3 is 75% stocks, 225% bonds --> same max drawdown as 60/40 (and same volatility as 100% stocks!)
*All are rebalanced quarterly*

Equity curves here ---> https://imgur.com/a/sDhfndl

Link to the actual PortfolioVisualizer backtest data

The math seems too good to be true so I'm sure I'm missing something. My main concern is the effect of rising interest rates on such a heavy bond portfolio. But if you're comfortable with a traditional 60/40 asset allocation - why wouldn't you use one of the equivalent leveraged portfolios above?

Side note: Using leveraged ETFs (25% SSO and 75% UST, for example) yielded worse results than borrowing on margin as expected.

grok87
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Re: Levering a portfolio to a 60/40 equivalent

Post by grok87 » Thu Jun 28, 2018 5:01 pm

birdec wrote:
Thu Jun 28, 2018 4:53 pm
What are your thoughts on levering a portfolio up to the equivalent of either a) the volatility of a 60/40 portfolio or b) the max drawdown of a 60/40 portfolio?

Portfolio 1 is 60% stocks (VFINX), 40% bonds (VBMFX)
Portfolio 2 is 50% stocks, 150% bonds --> same volatility as 60/40
Portfolio 3 is 75% stocks, 225% bonds --> same max drawdown as 60/40 (and same volatility as 100% stocks!)
*All are rebalanced quarterly*

Equity curves here ---> https://imgur.com/a/sDhfndl

Link to the actual PortfolioVisualizer backtest data

The math seems too good to be true so I'm sure I'm missing something. My main concern is the effect of rising interest rates on such a heavy bond portfolio. But if you're comfortable with a traditional 60/40 asset allocation - why wouldn't you use one of the equivalent leveraged portfolios above?

Side note: Using leveraged ETFs (25% SSO and 75% UST, for example) yielded worse results than borrowing on margin as expected.
You are backtesting against a period starting in the mid 80s when bond yields have massively declined. You should also backtest against a period of rising interest rates like from the 60s through 1981. If stocks and bonds both lose money at the same time then a leveraged portfolio like the ones you mention would probably be wiped out.


Cheers,
Grok
Keep calm and Boglehead on. KCBO.

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vineviz
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Re: Levering a portfolio to a 60/40 equivalent

Post by vineviz » Thu Jun 28, 2018 5:59 pm

Here’s a list of all the billionaires who got rich buying bonds on margin:
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

bmritz
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Re: Levering a portfolio to a 60/40 equivalent

Post by bmritz » Thu Jun 28, 2018 6:24 pm

Check out the following thread on using margin to buy a balanced fund -- viewtopic.php?f=10&t=143037.

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Tyler Aspect
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Re: Levering a portfolio to a 60/40 equivalent

Post by Tyler Aspect » Thu Jun 28, 2018 6:36 pm

Look at past performance historical record where a particular asset class had no losses; leverage up that asset class during that time. Risk will have seemingly disappeared, but only for that historical time period - not for the uncertain future.

There is certainly danger there, but it has been hidden by data mining techniques. That is why it feels "too good to be true".
Past result does not predict future performance. Mentioned investments may lose money. Contents are presented "AS IS" and any implied suitability for a particular purpose are disclaimed.

rhe
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Re: Levering a portfolio to a 60/40 equivalent

Post by rhe » Thu Jun 28, 2018 6:50 pm

I agree with the basic idea, which is that you should hold both stocks and bonds, and then use leverage to take the amount of risk that you want. This approach comes directly from modern portfolio theory.

I disagree with the idea of implementing this using margin. If you use treasury futures, the implied repo rate is something like 2% right now, which is (unsurprisingly) lower than 3 month libor. There's no way you're going to get a margin rate that low.

birdec
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Re: Levering a portfolio to a 60/40 equivalent

Post by birdec » Thu Jun 28, 2018 7:10 pm

I figured these would be the responses. So I guess my next question is how do you reconcile these statements:

1. Past performance does not predict future performance.
2. Use a diversified asset allocation because it's worked in the past.

People on here like to opine on market trends (rising rates, high equity valuations) but meaningfully adjusting one's portfolio to match those expectations goes against Boglehead philosophy. With rising rates and high equity valuations, is the consensus on the forum just that people should expect lower growth?

"It's foolish to leverage the most vanilla AA because of rising rates" would imply that you shouldn't even use that AA going forward. If leveraging a 25/75 AA is bad, is it also bad for a retiree to use 25/75?

Jags4186
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Re: Levering a portfolio to a 60/40 equivalent

Post by Jags4186 » Thu Jun 28, 2018 7:14 pm

birdec wrote:
Thu Jun 28, 2018 7:10 pm
I figured these would be the responses. So I guess my next question is how do you reconcile these statements:

1. Past performance does not predict future performance.
2. Use a diversified asset allocation because it's worked in the past.

People on here like to opine on market trends (rising rates, high equity valuations) but meaningfully adjusting one's portfolio to match those expectations goes against Boglehead philosophy. With rising rates and high equity valuations, is the consensus on the forum just that people should expect lower growth?

"It's foolish to leverage the most vanilla AA because of rising rates" would imply that you shouldn't even use that AA going forward. If leveraging a 25/75 AA is bad, is it also bad for a retiree to use 25/75?
The purpose of owning multiple diversified asset classes is not because “it worked in the past” but because we don’t know what the future holds. If you own everything, you’re guarranteed to own a portion of tomorrow’s big winner.

When you use leverage you magnify your wins and your losses. A 50% drop in a portfolio is awful but you still have money and could potentially recover. A 50% drop in a 2x leveraged portfolio and you’re wiped out—you cannot recover.

rhe
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Re: Levering a portfolio to a 60/40 equivalent

Post by rhe » Thu Jun 28, 2018 7:20 pm

...but the issue is that we don't choose to "own everything "! For example, I don't have any gold, uranium, or venezuelan bank loans in my portfolio. For some reason i've decided that those assets are not going to help, but on what basis have I made that decision ?

NoRegret
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Re: Levering a portfolio to a 60/40 equivalent

Post by NoRegret » Fri Jun 29, 2018 1:02 am

Birdec,

Nothing wrong with what you’re proposing in principle. That’s essentially how risk parity funds work.

Note that the benefit from holding negatively correlated assets is a mathematical fact. We’ve been in a disinflationary environment for a long time and stock/bond have had negative correlation, hence the observed performance. But the performance record is no more proof of the first statement than “I had an apple and you gave me another then I had two” is a proof of 1+1=2.

The dangers from rising inflation and positive stock/bond correlation are real, hence the warnings you have been given.

In practice what’s in your base portfolio, how you get leverage, risk management and market timing will be critical to your success.

Cheers,
NR
Market timer targeting long term cycles -- aiming for several key decisions per asset class per decade

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Tyler Aspect
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Re: Levering a portfolio to a 60/40 equivalent

Post by Tyler Aspect » Sat Jun 30, 2018 12:13 am

rhe wrote:
Thu Jun 28, 2018 7:20 pm
...but the issue is that we don't choose to "own everything "! For example, I don't have any gold, uranium, or venezuelan bank loans in my portfolio. For some reason i've decided that those assets are not going to help, but on what basis have I made that decision ?
You just have to know the difference between a suitable investment versus an unsuitable investment. Our total stock market index and total bond market index have accumulated a significant history of research and competitive success story. A random Venezuelan bank would be too not diversified to consider.
Past result does not predict future performance. Mentioned investments may lose money. Contents are presented "AS IS" and any implied suitability for a particular purpose are disclaimed.

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willthrill81
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Re: Levering a portfolio to a 60/40 equivalent

Post by willthrill81 » Sat Jun 30, 2018 9:30 am

birdec wrote:
Thu Jun 28, 2018 7:10 pm
So I guess my next question is how do you reconcile these statements:

1. Past performance does not predict future performance.
2. Use a diversified asset allocation because it's worked in the past.

People on here like to opine on market trends (rising rates, high equity valuations) but meaningfully adjusting one's portfolio to match those expectations goes against Boglehead philosophy. With rising rates and high equity valuations, is the consensus on the forum just that people should expect lower growth?

"It's foolish to leverage the most vanilla AA because of rising rates" would imply that you shouldn't even use that AA going forward. If leveraging a 25/75 AA is bad, is it also bad for a retiree to use 25/75?
You are correct; those two statements are irreconcilable. Those who truly believe that past performance is no indicator of future performance only have blind theories to use to help them invest. But virtually no one actually believes that. We all believe that past performance is some indicator of future performance, but it's level of precision varies significantly from one person to the next.

I do agree with others that we have to be very careful with backtesting and projecting its result for the future. Bonds had a nice tailwind for 30+ years in the form of generally falling interest rates, but that cannot be expected going forward for the next decade at the least.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

rhe
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Re: Levering a portfolio to a 60/40 equivalent

Post by rhe » Sat Jun 30, 2018 7:39 pm

I agree that bond performance has been unusually good since the 1980s, but people have looked at longer periods where interest rates have gone through several cycles, and there is still a substantial benefit to holding both stocks and bonds.

One interesting thing about bonds is that once you have decided to use leverage you can consider short duration bonds. Past data suggests that two year treasuries leveraged 5x have substantially better performance than a 10 year treasury, even taking into account transaction costs.

garlandwhizzer
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Re: Levering a portfolio to a 60/40 equivalent

Post by garlandwhizzer » Sat Jun 30, 2018 8:53 pm

grok87 wrote:
You are backtesting against a period starting in the mid 80s when bond yields have massively declined. You should also backtest against a period of rising interest rates like from the 60s through 1981. If stocks and bonds both lose money at the same time then a leveraged portfolio like the ones you mention would probably be wiped out.
vineviz wrote:
Here’s a list of all the billionaires who got rich buying bonds on margin:
Both of these are great quotes and make the point effectively. A highly leveraged bond portfolio going forward from here is not a good idea IMO. Backtesting through mid 1980s to mid 2010s, the greatest bond bull market in history, looks promising but the likelihood that the bond market's future going forward will be a replay of that past is not low, it is zero. From 1940 to 1980 a bond portfolio of rolling ten year Treasuries produced 40 years of negative real returns for 4 decades. You lost purchasing power for 40 years. If leverage had been used during that time span, losses would have been magnified. In mid 1980s, bond backtesting results looked horrible, 4 decades of losses. Bonds were so devastated that 10 year Treasuries yielded 15% in 1982. These high yields in a time of high inflation set the stage for its greatest bull market ever as inflation/yields consistently declined for 30+ years. The stage is not set for another such bull market event now.

Backtesting has real limits in providing reliable insight into the market's future.

Garland Whizzer

rhe
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Re: Levering a portfolio to a 60/40 equivalent

Post by rhe » Sun Jul 01, 2018 5:01 am

"Most of the gains realized by a yield curve carry portfolio over the past 20 years are explained by riding the yield curve and not by falling interest rates;"

https://www.google.com/url?sa=t&source= ... v4Az-LTyPi

On the one hand, most of the people who have written papers or notes on this seem to be involved with these instruments in some way, and so might be biased. On the other hand, the exercise they did was pretty simple and looks reasonable to me.

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willthrill81
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Re: Levering a portfolio to a 60/40 equivalent

Post by willthrill81 » Sun Jul 01, 2018 9:19 pm

rhe wrote:
Sun Jul 01, 2018 5:01 am
"Most of the gains realized by a yield curve carry portfolio over the past 20 years are explained by riding the yield curve and not by falling interest rates;"

https://www.google.com/url?sa=t&source= ... v4Az-LTyPi

On the one hand, most of the people who have written papers or notes on this seem to be involved with these instruments in some way, and so might be biased. On the other hand, the exercise they did was pretty simple and looks reasonable to me.
I read an academic paper last year (can't remember the authors) who came to a similar conclusion: falling interest rates from the early 1980s until the 2010s improved bond returns by an estimated 1% annually compared to flat interest rates. That's a nice tailwind, to be sure, but I don't see that as being nearly as big of an issue as many believe. I personally doubt very much that we're going to go back to double-digit interest rates any time soon, so the headwind of rising rates faced by bonds currently might not reduce returns by more than perhaps .5% annually compared to flat rates. But ultimately, bond holders should want interest rates to be higher so that they can get higher yield, the primary source of bonds' returns. Only the short-term oriented person should really be concerned about rising rates, IMHO.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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