Indexing on leverage?

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alex123711
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Indexing on leverage?

Post by alex123711 » Thu Apr 11, 2019 2:39 am

What's the general consensus of doing this? Since over the long term the index should go up wouldn't it be better to buy more using leverage? Is it that much different to buying a house with a mortgage.. (apart from possible margin calls)

Valuethinker
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Re: Indexing on leverage?

Post by Valuethinker » Thu Apr 11, 2019 3:01 am

alex123711 wrote:
Thu Apr 11, 2019 2:39 am
What's the general consensus of doing this? Since over the long term the index should go up wouldn't it be better to buy more using leverage? Is it that much different to buying a house with a mortgage.. (apart from possible margin calls)
Aye, therein lies the rub. The market can go the wrong way longer than your ability to hold the position lasts.

In effect the small investor is short volatility (if leveraged) and the other side is long volatility. It's the same principle that means a martingale strategy at the casino fails.

You see this with hedge fund strategies that are "picking up nickels instead of bulldozers". Every so often the HF just goes broke - clients lose their money. Read "When Genius Failed" by Roger Lowenstein about LTCM's failure.

Spread betting firms are the ultimate of this. The reason they advertise so heavily at football (soccer in American language) games is that their clients keep getting wiped out (short volatility) and they need new customers - generally those customers will be male, under 45 or 50, classic televised football audience.

afan
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Re: Indexing on leverage?

Post by afan » Thu Apr 11, 2019 5:20 am

Your leveraged portfolio has to do well enough to cover the cost of borrowing and the increased risk. Individuals cannot borrow at the T bill rate, so that cost would be substantial. You need to have enough liquidity to survive steep market drops, or sell out during those drops to satisfy the margin call. Keeping higher liquidity reduces your total stock exposure but does so at a higher cost than an unleveraged portfolio with the same overall exposure.

Leverage increases your risk. If you do well enough to cover your borrowing costs you could still trail an unleveraged portfolio on a risk adjusted basis.

I am always skeptical of predictions about future market returns. For what it is worth, those who believe they can do this are forecasting low returns. Some are also predicting rising interest rates. These would reduce your returns and increase the costs of the leveraged portfolio.

Maybe if you have a highly reliable high income and a small portfolio you could cover margin calls with new revenue. But market drops often happen too fast for paychecks to do the job.

A little leverage is safer than a lot, but also has limited effect.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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pezblanco
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Re: Indexing on leverage?

Post by pezblanco » Thu Apr 11, 2019 4:46 pm

Valuethinker wrote:
Thu Apr 11, 2019 3:01 am
alex123711 wrote:
Thu Apr 11, 2019 2:39 am
What's the general consensus of doing this? Since over the long term the index should go up wouldn't it be better to buy more using leverage? Is it that much different to buying a house with a mortgage.. (apart from possible margin calls)
Aye, therein lies the rub. The market can go the wrong way longer than your ability to hold the position lasts.

In effect the small investor is short volatility (if leveraged) and the other side is long volatility. It's the same principle that means a martingale strategy at the casino fails.

You see this with hedge fund strategies that are "picking up nickels instead of bulldozers". Every so often the HF just goes broke - clients lose their money. Read "When Genius Failed" by Roger Lowenstein about LTCM's failure.

Spread betting firms are the ultimate of this. The reason they advertise so heavily at football (soccer in American language) games is that their clients keep getting wiped out (short volatility) and they need new customers - generally those customers will be male, under 45 or 50, classic televised football audience.
Mathematically, there is a big difference between playing/trying to beat an unfair game (like using a martingale betting strategy in a casino) and playing a fair game (a game with positive expectation on every bet). Bet sizing is important in the latter and you never bet your whole fortune on a single outcome as you want to stay in the game as long as possible) ...

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pezblanco
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Re: Indexing on leverage?

Post by pezblanco » Thu Apr 11, 2019 4:49 pm

afan wrote:
Thu Apr 11, 2019 5:20 am
Your leveraged portfolio has to do well enough to cover the cost of borrowing and the increased risk. Individuals cannot borrow at the T bill rate, so that cost would be substantial. You need to have enough liquidity to survive steep market drops, or sell out during those drops to satisfy the margin call. Keeping higher liquidity reduces your total stock exposure but does so at a higher cost than an unleveraged portfolio with the same overall exposure.

Leverage increases your risk. If you do well enough to cover your borrowing costs you could still trail an unleveraged portfolio on a risk adjusted basis.

I am always skeptical of predictions about future market returns. For what it is worth, those who believe they can do this are forecasting low returns. Some are also predicting rising interest rates. These would reduce your returns and increase the costs of the leveraged portfolio.

Maybe if you have a highly reliable high income and a small portfolio you could cover margin calls with new revenue. But market drops often happen too fast for paychecks to do the job.

A little leverage is safer than a lot, but also has limited effect.
I think that from the recent discussions centered around how to leverage, you basically can borrow at very low rates (say the 3-month Libor) by the use of rolling futures contracts. Leveraging levels of 1.5 or so seem warranted ... while not giving you instant wealth, they could certainly substantially juice returns.

TomCat96
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Re: Indexing on leverage?

Post by TomCat96 » Thu Apr 11, 2019 5:11 pm

A few times I have advocated for a 100% equity position, rebuffed with the counterargument that 100% is an arbitrary number--that if one is 100% equities, then surely it is no different from being 110%, or 120%.

Aside from not paying off existing loans(mortgage or student), that counterargument seems to be fallacious. No. 100% is no mere arbitrary number. It is significant because beyond that you will have to borrow, are subjected to rules of leveraging, may be subject to margin calls, may be liquidated if you fail to meet a margin call,

Indeed as people have said here, indexing on leverage requires borrowing which you cannot do at the treasury rate.
You must do better than a certain percentage over a given period of time. If the market were to crash, you are leveraged with respect to that crash, and are subject to a large set of rules.

There is the option of course of Options. A few articles pushing for deep in the money warrants on indexes exist.
But any time you deal with peculiar securities, you're entering new territory in my opinion. And there still remains the possibility of course that your warrants may expire worthless.

The leveraged SPDRs are peculiar entities. When I researched getting into them, they require entering and exiting at certain points in the day, at which point a 2x or 3x leverage on an index could be done. But these do not grow at 2x or 3x the growth rate of the SP500 as a general index.

One of the key attributes of index investing, implicit, in the boglehead formulation is that the portfolio is time agnostic.
Whether the market crashes or soars, you don't care. Market timing, the thing that nobody can do accurately, is picking when.

Leveraging can be seen as a softer version of timing, but in the sense that it exposes you to the same risks, I would argue it is market timing.
I say its a softer form because it the timing attributes depend on the degree to which you are leveraged.

So let me create a simple scenario. Suppose you are leveraged 2:1. Then you are market timing. You are market timing because you are betting for the duration you are leveraged the market will not drop more than 50%. If it occurs, your position is liquidated. Though you did not pick a specific date in which you engaged in said market timing, and though in some sense it does not feel like timing, you are subjecting your portfolio to timing forces... which is the same thing in principle.

Just because I can't pick exactly which number the roulette ball is going to land on, doesn't mean that betting on red or black is a good alternative.

ThrustVectoring
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Re: Indexing on leverage?

Post by ThrustVectoring » Thu Apr 11, 2019 5:17 pm

"Stocks yield more than the borrowing costs, so this has a positive expected value" isn't the whole story. If you maintain a fixed leverage ratio, the more leverage you use, the more you need to do buy-high/sell-low trading. If you have a $10k stake in $20k of stock, and it goes up by 10%, you wind up with a $12k stake in $22k of stock, which has less than the 2:1 leverage ratio you desire. Conversely, if your assets decline in value, you have to sell to reduce risk because your leverage magnifies both gains and losses.

This is "volatility drag". If you hear people talk about a "rebalancing bonus", that's negative volatility drag for having negative leverage, essentially.

The "Kelly Criterion" is some relatively straightforward math that takes the expected amount of excess return and the expected amount of volatility drag, and spits out the point where adding leverage stops helping your returns. For the US stock market, reasonably conservative assumptions here gives you a number for leverage that's something like 1.4

NB: you want to use less leverage than the Kelly Criterion suggests, for a couple reasons. First, your assumptions can be wrong, and it's way better to use too little leverage than too much when that happens. Second, the Kelly portfolio maximizes expected return, and you do care a lot about the variance involved, which is considerable for a Kelly portfolio.

You can also use call options to limit the downside risk to covering option premia with new savings. Gamma is pretty expensive though, so it's not clear that this will help you out any. It's probably better to just focus on minimizing costs through a 100% equity index fund portfolio.
Current portfolio: 60% VTI / 40% VXUS

jdilla1107
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Re: Indexing on leverage?

Post by jdilla1107 » Thu Apr 11, 2019 7:38 pm

People on this forum give all sorts of nuanced answers to this question and miss the absolutely critical point.

Equity margin is callable. This means if stocks drop, you will have to put up more cash immediately. Where will this cash come from? If you don't have the cash, your position is immediately liquidated permanently locking in the losses.

This is completely different than leverage in real estate. In real estate, the bank can't come to you demanding more money if real estate prices fall. You can wait it out without adding cash into your mortgage.

This is a CRITICALLY important difference. It makes all the difference in the world.

If someone were to offer equity margin that wasn't callable (I think this would be illegal), then investing on margin would make a ton of sense since you could just wait out the volatility. But, callable equity leverage pretty much only makes sense for various structural cases, (eg: legal tax avoidance, cash movements, arbitrage) because you can be forced into permanent losses.

MotoTrojan
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Re: Indexing on leverage?

Post by MotoTrojan » Thu Apr 11, 2019 9:37 pm

TomCat96 wrote:
Thu Apr 11, 2019 5:11 pm
The leveraged SPDRs are peculiar entities. When I researched getting into them, they require entering and exiting at certain points in the day, at which point a 2x or 3x leverage on an index could be done. But these do not grow at 2x or 3x the growth rate of the SP500 as a general index.
Not sure what you mean by the entering and exiting. These funds track a 2x or 3x daily return, hence not matching 2x or 3x long-term return. This can hurt you in some situations, such as a flat market where volatility drag will still cause the fund to go down over time. It can also boost returns even more-so; since inception I believe UPRO (a 3x fund) is up >5x the S&P500 total return. TQQQ (the 3x NASDAQ) would've turned $100K into $8.5M in less than a decade, last I checked.

There are a couple of recent threads out there that have been extremely educational for me on leverage.

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whodidntante
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Re: Indexing on leverage?

Post by whodidntante » Thu Apr 11, 2019 9:49 pm

Most people that I know are leveraged in some way. I am also. The companies you own through an index fund are leveraged. Even my governments are leveraged. And wealth to GDP is quite high right now. We'll all get rich shuffling our borrowed money to each other. It's gonna be great.

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pezblanco
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Re: Indexing on leverage?

Post by pezblanco » Fri Apr 12, 2019 8:50 am

jdilla1107 wrote:
Thu Apr 11, 2019 7:38 pm
People on this forum give all sorts of nuanced answers to this question and miss the absolutely critical point.

Equity margin is callable. This means if stocks drop, you will have to put up more cash immediately. Where will this cash come from? If you don't have the cash, your position is immediately liquidated permanently locking in the losses.

This is completely different than leverage in real estate. In real estate, the bank can't come to you demanding more money if real estate prices fall. You can wait it out without adding cash into your mortgage.

This is a CRITICALLY important difference. It makes all the difference in the world.

If someone were to offer equity margin that wasn't callable (I think this would be illegal), then investing on margin would make a ton of sense since you could just wait out the volatility. But, callable equity leverage pretty much only makes sense for various structural cases, (eg: legal tax avoidance, cash movements, arbitrage) because you can be forced into permanent losses.
The idea is to not maximize your leverage ... but choose a moderate amount where you have enough margin in the account to let you take downswings that even if the stock market had a historic drop, you wouldn't be sold out of your position.

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pezblanco
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Re: Indexing on leverage?

Post by pezblanco » Fri Apr 12, 2019 8:56 am

MotoTrojan wrote:
Thu Apr 11, 2019 9:37 pm
TomCat96 wrote:
Thu Apr 11, 2019 5:11 pm
The leveraged SPDRs are peculiar entities. When I researched getting into them, they require entering and exiting at certain points in the day, at which point a 2x or 3x leverage on an index could be done. But these do not grow at 2x or 3x the growth rate of the SP500 as a general index.
Not sure what you mean by the entering and exiting. These funds track a 2x or 3x daily return, hence not matching 2x or 3x long-term return. This can hurt you in some situations, such as a flat market where volatility drag will still cause the fund to go down over time. It can also boost returns even more-so; since inception I believe UPRO (a 3x fund) is up >5x the S&P500 total return. TQQQ (the 3x NASDAQ) would've turned $100K into $8.5M in less than a decade, last I checked.

There are a couple of recent threads out there that have been extremely educational for me on leverage.
I know that this is a "feature" and "not a bug" of the leveraged SPDRs. I personally think that it is one more level of complication to an already risky strategy. For example, suppose we have a choice of monthly resets, yearly resets, or daily resets in funds that provide 3x leverage. Would you choose the daily reset? Would you pay more for it? I personally think that with the use of futures or options a reset on the order of no more than quarterly would make me sleep better at night.

pdavi21
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Re: Indexing on leverage?

Post by pdavi21 » Fri Apr 12, 2019 9:03 am

I think it would be better to just go 100% stocks, then tilt to small cap (or small cap value), then take out a mortgage for leverage, then consider some zero/low interest credit/margin if your income is rock solid, and you can cover the debt at any time with a depleted portfolio.

Of course, the first step (100% stocks) is too risky for a majority of investors, and all the other steps are unlikely to yield positive results.

EDIT: Stay away from leveraged ETFs. Everyone is ignoring the fact that INTL 3x ETFs mostly underperformed the underlying asset from most of the bottom of the 2008-2009 crash. INTL stocks returned over 100%, and the leveraged ETFs returned LESS.
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

FireProof
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Re: Indexing on leverage?

Post by FireProof » Fri Apr 12, 2019 9:17 am

Funny no one talked about this when LIBOR was near 0 and market was low, from 2009 to 2015 (although I was leveraged around 1.5 to 1.8 from 2011 through 2013, for time diversification purposes at the beginning of my career). Now that market has reached astronomical heights and borrowing costs have become significant, everyone want in. I guess it's like the sudden popularity of Bitcoin once it reached 18000, and it shows why investors underperform the market so drastically.

MotoTrojan
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Re: Indexing on leverage?

Post by MotoTrojan » Fri Apr 12, 2019 10:08 am

pezblanco wrote:
Fri Apr 12, 2019 8:56 am
MotoTrojan wrote:
Thu Apr 11, 2019 9:37 pm
TomCat96 wrote:
Thu Apr 11, 2019 5:11 pm
The leveraged SPDRs are peculiar entities. When I researched getting into them, they require entering and exiting at certain points in the day, at which point a 2x or 3x leverage on an index could be done. But these do not grow at 2x or 3x the growth rate of the SP500 as a general index.
Not sure what you mean by the entering and exiting. These funds track a 2x or 3x daily return, hence not matching 2x or 3x long-term return. This can hurt you in some situations, such as a flat market where volatility drag will still cause the fund to go down over time. It can also boost returns even more-so; since inception I believe UPRO (a 3x fund) is up >5x the S&P500 total return. TQQQ (the 3x NASDAQ) would've turned $100K into $8.5M in less than a decade, last I checked.

There are a couple of recent threads out there that have been extremely educational for me on leverage.
I know that this is a "feature" and "not a bug" of the leveraged SPDRs. I personally think that it is one more level of complication to an already risky strategy. For example, suppose we have a choice of monthly resets, yearly resets, or daily resets in funds that provide 3x leverage. Would you choose the daily reset? Would you pay more for it? I personally think that with the use of futures or options a reset on the order of no more than quarterly would make me sleep better at night.
I can agree with that. Quarterly reset aligned with rebalancing would probably be my winner. Not there yet in terms of knowing how to implement.

MotoTrojan
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Re: Indexing on leverage?

Post by MotoTrojan » Fri Apr 12, 2019 10:12 am

pdavi21 wrote:
Fri Apr 12, 2019 9:03 am
I think it would be better to just go 100% stocks, then tilt to small cap (or small cap value), then take out a mortgage for leverage, then consider some zero/low interest credit/margin if your income is rock solid, and you can cover the debt at any time with a depleted portfolio.

Of course, the first step (100% stocks) is too risky for a majority of investors, and all the other steps are unlikely to yield positive results.

EDIT: Stay away from leveraged ETFs. Everyone is ignoring the fact that INTL 3x ETFs mostly underperformed the underlying asset from most of the bottom of the 2008-2009 crash. INTL stocks returned over 100%, and the leveraged ETFs returned LESS.
The international variants have done a poor job of tracking their target index. Why is that a blanket statement to avoid outright?

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greg24
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Re: Indexing on leverage?

Post by greg24 » Fri Apr 12, 2019 10:16 am

Smells like greed.

jdilla1107
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Re: Indexing on leverage?

Post by jdilla1107 » Fri Apr 12, 2019 10:45 am

pezblanco wrote:
Fri Apr 12, 2019 8:50 am
jdilla1107 wrote:
Thu Apr 11, 2019 7:38 pm
People on this forum give all sorts of nuanced answers to this question and miss the absolutely critical point.

Equity margin is callable. This means if stocks drop, you will have to put up more cash immediately. Where will this cash come from? If you don't have the cash, your position is immediately liquidated permanently locking in the losses.

This is completely different than leverage in real estate. In real estate, the bank can't come to you demanding more money if real estate prices fall. You can wait it out without adding cash into your mortgage.

This is a CRITICALLY important difference. It makes all the difference in the world.

If someone were to offer equity margin that wasn't callable (I think this would be illegal), then investing on margin would make a ton of sense since you could just wait out the volatility. But, callable equity leverage pretty much only makes sense for various structural cases, (eg: legal tax avoidance, cash movements, arbitrage) because you can be forced into permanent losses.
The idea is to not maximize your leverage ... but choose a moderate amount where you have enough margin in the account to let you take downswings that even if the stock market had a historic drop, you wouldn't be sold out of your position.
So, we are talking around 20% leverage? 100% equities will be hardly different than 120% equities, especially with borrowing costs.

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pezblanco
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Re: Indexing on leverage?

Post by pezblanco » Fri Apr 12, 2019 11:01 am

jdilla1107 wrote:
Fri Apr 12, 2019 10:45 am
pezblanco wrote:
Fri Apr 12, 2019 8:50 am
jdilla1107 wrote:
Thu Apr 11, 2019 7:38 pm
People on this forum give all sorts of nuanced answers to this question and miss the absolutely critical point.

Equity margin is callable. This means if stocks drop, you will have to put up more cash immediately. Where will this cash come from? If you don't have the cash, your position is immediately liquidated permanently locking in the losses.

This is completely different than leverage in real estate. In real estate, the bank can't come to you demanding more money if real estate prices fall. You can wait it out without adding cash into your mortgage.

This is a CRITICALLY important difference. It makes all the difference in the world.

If someone were to offer equity margin that wasn't callable (I think this would be illegal), then investing on margin would make a ton of sense since you could just wait out the volatility. But, callable equity leverage pretty much only makes sense for various structural cases, (eg: legal tax avoidance, cash movements, arbitrage) because you can be forced into permanent losses.
The idea is to not maximize your leverage ... but choose a moderate amount where you have enough margin in the account to let you take downswings that even if the stock market had a historic drop, you wouldn't be sold out of your position.
So, we are talking around 20% leverage? 100% equities will be hardly different than 120% equities, especially with borrowing costs.
If you are talking about 5% real return on stocks and very close to zero real borrowing costs, then we could increase returns by say up to 7-8% by leveraging out to 40-50%. It's not winning the lottery but it's certainly not something to turn your nose up at.

jdilla1107
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Re: Indexing on leverage?

Post by jdilla1107 » Fri Apr 12, 2019 11:16 am

pezblanco wrote:
Fri Apr 12, 2019 11:01 am
jdilla1107 wrote:
Fri Apr 12, 2019 10:45 am
pezblanco wrote:
Fri Apr 12, 2019 8:50 am
jdilla1107 wrote:
Thu Apr 11, 2019 7:38 pm
People on this forum give all sorts of nuanced answers to this question and miss the absolutely critical point.

Equity margin is callable. This means if stocks drop, you will have to put up more cash immediately. Where will this cash come from? If you don't have the cash, your position is immediately liquidated permanently locking in the losses.

This is completely different than leverage in real estate. In real estate, the bank can't come to you demanding more money if real estate prices fall. You can wait it out without adding cash into your mortgage.

This is a CRITICALLY important difference. It makes all the difference in the world.

If someone were to offer equity margin that wasn't callable (I think this would be illegal), then investing on margin would make a ton of sense since you could just wait out the volatility. But, callable equity leverage pretty much only makes sense for various structural cases, (eg: legal tax avoidance, cash movements, arbitrage) because you can be forced into permanent losses.
The idea is to not maximize your leverage ... but choose a moderate amount where you have enough margin in the account to let you take downswings that even if the stock market had a historic drop, you wouldn't be sold out of your position.
So, we are talking around 20% leverage? 100% equities will be hardly different than 120% equities, especially with borrowing costs.
If you are talking about 5% real return on stocks and very close to zero real borrowing costs, then we could increase returns by say up to 7-8% by leveraging out to 40-50%. It's not winning the lottery but it's certainly not something to turn your nose up at.
50% leverage means that the smallest downturn will result in a margin call. You responded to my comment with "The idea is to not maximize your leverage". 50% is maximizing your leverage.

Everyone on this forum talks about leverage as an academic concept. It's the actual real-world mechanics that make it not work.

tmcc
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Re: Indexing on leverage?

Post by tmcc » Fri Apr 12, 2019 12:28 pm

jdilla1107 wrote:
Fri Apr 12, 2019 11:16 am
pezblanco wrote:
Fri Apr 12, 2019 11:01 am
jdilla1107 wrote:
Fri Apr 12, 2019 10:45 am
pezblanco wrote:
Fri Apr 12, 2019 8:50 am
jdilla1107 wrote:
Thu Apr 11, 2019 7:38 pm
People on this forum give all sorts of nuanced answers to this question and miss the absolutely critical point.

Equity margin is callable. This means if stocks drop, you will have to put up more cash immediately. Where will this cash come from? If you don't have the cash, your position is immediately liquidated permanently locking in the losses.

This is completely different than leverage in real estate. In real estate, the bank can't come to you demanding more money if real estate prices fall. You can wait it out without adding cash into your mortgage.

This is a CRITICALLY important difference. It makes all the difference in the world.

If someone were to offer equity margin that wasn't callable (I think this would be illegal), then investing on margin would make a ton of sense since you could just wait out the volatility. But, callable equity leverage pretty much only makes sense for various structural cases, (eg: legal tax avoidance, cash movements, arbitrage) because you can be forced into permanent losses.
The idea is to not maximize your leverage ... but choose a moderate amount where you have enough margin in the account to let you take downswings that even if the stock market had a historic drop, you wouldn't be sold out of your position.
So, we are talking around 20% leverage? 100% equities will be hardly different than 120% equities, especially with borrowing costs.
If you are talking about 5% real return on stocks and very close to zero real borrowing costs, then we could increase returns by say up to 7-8% by leveraging out to 40-50%. It's not winning the lottery but it's certainly not something to turn your nose up at.

50% leverage means that the smallest downturn will result in a margin call. You responded to my comment with "The idea is to not maximize your leverage". 50% is maximizing your leverage.


Everyone on this forum talks about leverage as an academic concept. It's the actual real-world mechanics that make it not work.
I don't really follow your statement. however, i'm just a simpleton though, so maybe you're saying the same thing as what I'm about to lay out.

if you have 100k in equity available for leverage and you buy another 100k, youre 200k equity, -100k cash. this is 100% leverage @ 2:1. if you lose 10% on that 200k position, your balance is now 180k equity, -100k cash. If you get called, you are down 20k in equity, your equity is liquidated to the extent of negative cash -- net net, equity is 80k and cash is 0k. you would have to lose 50% of your fully leveraged position to wipe out your original holdings. ie, 100k equity, -100k cash -- net net $0 left. that is a 50% underlying security reduction (200k -> 100k). this is not a "smallest downturn" margin call. ouch!

now, if you only use 50% of available leverage @ 2:1, then you are 150k equity, -50k cash. the index would have to drop 66% for you to be wiped out. ie, equity declines to 50k, cash is -50k, net holdings are now 0. ouch 8-)

the gotcha that people sometimes don't recognize is that the exchange or broker can suddenly change the leverage rules or margin requirements with no notice. this is a particularly big risk with individual stocks.

EfficientInvestor
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Re: Indexing on leverage?

Post by EfficientInvestor » Fri Apr 12, 2019 1:07 pm

OP - The appropriate use of leverage can be very useful and provide much better risk-adjusted returns than being 100% stock. Borrowing money on margin is mostly a bad idea due to margin calls and rates that are charged. Futures are optimal but leveraged ETFs make a decent substitute. Portfolio 1 from the backtest below uses a 2X stock fund and a long term treasury fund that is used as an approximation for a 2x intermediate treasury fund (e.g. UST). Portfolio 2 represents the approximate returns of rolling S&P 500 and 5-year treasury futures contracts. Both have better returns than the S&P 500 since Dec 1997 and both had less than a 20% max drawdown. No guarantee of this happening again, but it’s worth consideration.

https://www.portfoliovisualizer.com/bac ... on5_2=-100

DonIce
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Re: Indexing on leverage?

Post by DonIce » Fri Apr 12, 2019 1:17 pm

jdilla1107 wrote:
Fri Apr 12, 2019 11:16 am
50% leverage means that the smallest downturn will result in a margin call. You responded to my comment with "The idea is to not maximize your leverage". 50% is maximizing your leverage.

Everyone on this forum talks about leverage as an academic concept. It's the actual real-world mechanics that make it not work.
This is wrong. 50% margin leverage allows for a significant market downturn before you get called. Margin ratio = (stock equity - borrowed dollars)/equity

So if you start with $100k and invest $150k ($50k on margin), your margin ratio = ($150k-$50k)/$150k = 0.67.

This needs to fall to 0.5 for you to get a margin call. That happens when:

($100k-$50k)/$100k = 0.5

So the market price needs to fall by 33.3%, reducing the value of your investment from $150k to $100k, before you get a margin call. Margin loans can be obtained at as low as 2.71% at IB for large margin balances (3.9% for small margin balances).

Additionally, there are multiple other ways to implement leverage:

1) Buy long dated call options. For example, right now I could buy Dec 2021 calls on SPY at $97.18. These offer a leverage of about 2.76x (if SPY goes up to 400, that's a gain of 38% relative to the current value, but the option will go up from the price of $97.18 to about $200, which is a 105% gain). The time value of this option is $200+$97.18 -$ 290 = $7.18. That's over 2 years 8 months, so an annual cost of $7.18/$97.18/2.67 = 2.76%. In addition you miss out on dividends (~2%) so the rate to achieve leverage this way is ~4.76%. This leverage is NOT callable.

2) Take out money using a HELOC from your home equity. You can get these at about 4.75%. Also not callable.

3) Buy futures. For ES mini futures, the maintenance margin is $6000. If you take a 50% leveraged position using ES mini futures, for example if your account size is $100k and you buy 1 future contract that has a notional value of $150k (if the S&P500 was at 3000, for round numbers). Your account has $100k in cash/T-bills and its net value needs to drop to $6000 before you get liquidated. For that to happen, the contract would need to drop from its value of $150k to $150k-($100-$6k) = $56k. That's a 63% market drop before you get called (although it is possible margin requirements could be increased during times of increased market volatility). The implied financing rate with ES mini futures is 0.7% + the lost dividends (2%) = 2.7%. Callable leverage is cheaper than non-callable leverage.

Based on these 4 options above (margin, options, futures, HELOC) you can see that you have the choice of using either callable leverage at about 2.7% or non-callable leverage at about 4.7%. You pay a 2% premium for non-callability, which may or may not be worthwhile depending the leverage ratio you are trying to pursue and your availability of additional funds to avoid margin calls if you use callable leverage.

jdilla1107
Posts: 849
Joined: Sun Jun 24, 2012 8:31 pm

Re: Indexing on leverage?

Post by jdilla1107 » Fri Apr 12, 2019 1:52 pm

DonIce wrote:
Fri Apr 12, 2019 1:17 pm
jdilla1107 wrote:
Fri Apr 12, 2019 11:16 am
50% leverage means that the smallest downturn will result in a margin call. You responded to my comment with "The idea is to not maximize your leverage". 50% is maximizing your leverage.

Everyone on this forum talks about leverage as an academic concept. It's the actual real-world mechanics that make it not work.
This is wrong. 50% margin leverage allows for a significant market downturn before you get called. Margin ratio = (stock equity - borrowed dollars)/equity

So if you start with $100k and invest $150k ($50k on margin), your margin ratio = ($150k-$50k)/$150k = 0.67.

This needs to fall to 0.5 for you to get a margin call. That happens when:

($100k-$50k)/$100k = 0.5

So the market price needs to fall by 33.3%, reducing the value of your investment from $150k to $100k, before you get a margin call. Margin loans can be obtained at as low as 2.71% at IB for large margin balances (3.9% for small margin balances).

Additionally, there are multiple other ways to implement leverage:

1) Buy long dated call options. For example, right now I could buy Dec 2021 calls on SPY at $97.18. These offer a leverage of about 2.76x (if SPY goes up to 400, that's a gain of 38% relative to the current value, but the option will go up from the price of $97.18 to about $200, which is a 105% gain). The time value of this option is $200+$97.18 -$ 290 = $7.18. That's over 2 years 8 months, so an annual cost of $7.18/$97.18/2.67 = 2.76%. In addition you miss out on dividends (~2%) so the rate to achieve leverage this way is ~4.76%. This leverage is NOT callable.

2) Take out money using a HELOC from your home equity. You can get these at about 4.75%. Also not callable.

3) Buy futures. For ES mini futures, the maintenance margin is $6000. If you take a 50% leveraged position using ES mini futures, for example if your account size is $100k and you buy 1 future contract that has a notional value of $150k (if the S&P500 was at 3000, for round numbers). Your account has $100k in cash/T-bills and its net value needs to drop to $6000 before you get liquidated. For that to happen, the contract would need to drop from its value of $150k to $150k-($100-$6k) = $56k. That's a 63% market drop before you get called (although it is possible margin requirements could be increased during times of increased market volatility). The implied financing rate with ES mini futures is 0.7% + the lost dividends (2%) = 2.7%. Callable leverage is cheaper than non-callable leverage.

Based on these 4 options above (margin, options, futures, HELOC) you can see that you have the choice of using either callable leverage at about 2.7% or non-callable leverage at about 4.7%. You pay a 2% premium for non-callability, which may or may not be worthwhile depending the leverage ratio you are trying to pursue and your availability of additional funds to avoid margin calls if you use callable leverage.
In my post, I meant "50%" as half equity and half debt, which you are calling 2:1 or 100% leverage.

1) Options: What if I am running an equity allocation at 150% and then interest rates increase and the stock market goes down? I am borrowing at a floating rate of interest to make a long term investment.

2) HELOC: What happens if the real estate market drops and I am forced to move due to a job change? (I have heard other countries have permanent mortgages which seems neat.)

3) Futures: Same as 1, but worse because of how futures are settled.

Do you employ an equity allocation above 100%?

DonIce
Posts: 882
Joined: Thu Feb 21, 2019 6:44 pm

Re: Indexing on leverage?

Post by DonIce » Fri Apr 12, 2019 2:01 pm

jdilla1107 wrote:
Fri Apr 12, 2019 1:52 pm
What you need is a 30-40 year fixed rate loan.
You can get fixed rate loans backed by your stock holdings. For example, here's a 12 year 4.75% fixed rate loan:
https://www.firsttechfed.com/Loans/Pers ... cured-Loan
Do you employ an equity allocation above 100%?
No, but if we had another 50% market drop happen I would probably increase my equity allocation to well above 100% :) Not gonna leverage into a market that is at (or very close to) its historic high.

ThrustVectoring
Posts: 771
Joined: Wed Jul 12, 2017 2:51 pm

Re: Indexing on leverage?

Post by ThrustVectoring » Fri Apr 12, 2019 2:19 pm

DonIce wrote:
Fri Apr 12, 2019 2:01 pm
jdilla1107 wrote:
Fri Apr 12, 2019 1:52 pm
What you need is a 30-40 year fixed rate loan.
You can get fixed rate loans backed by your stock holdings. For example, here's a 12 year 4.75% fixed rate loan:
https://www.firsttechfed.com/Loans/Pers ... cured-Loan
Taking out a fixed rate loan is technically equivalent to taking out a floating rate loan, shorting a bond with the same payment schedule, and buying a call option to close out your short position for the outstanding principle. You can likely engineer better rates through using the interest rate futures markets explicitly. It's also not entirely clear that you want the implied call option anyhow - if financing costs fall, you're fine with having lower financing costs on your stock position that offset the losses on the futures contract. Maybe it's entirely risk management considerations for that element.
Current portfolio: 60% VTI / 40% VXUS

DonIce
Posts: 882
Joined: Thu Feb 21, 2019 6:44 pm

Re: Indexing on leverage?

Post by DonIce » Fri Apr 12, 2019 2:23 pm

ThrustVectoring wrote:
Fri Apr 12, 2019 2:19 pm
Taking out a fixed rate loan is technically equivalent to taking out a floating rate loan, shorting a bond with the same payment schedule, and buying a call option to close out your short position for the outstanding principle. You can likely engineer better rates through using the interest rate futures markets explicitly. It's also not entirely clear that you want the implied call option anyhow - if financing costs fall, you're fine with having lower financing costs on your stock position that offset the losses on the futures contract. Maybe it's entirely risk management considerations for that element.
Personally if I was using a leveraged strategy I'd stick with a floating rate, callable, method. This is the cheapest way to get the financing and you typically get it at right near the T-bill rate. The higher the spread you're paying above the risk-free rate the more you're bargaining that you timed the market right rather than just investing passively.

pdavi21
Posts: 1296
Joined: Sat Jan 30, 2016 4:04 pm

Re: Indexing on leverage?

Post by pdavi21 » Fri Apr 12, 2019 2:38 pm

..........
Last edited by pdavi21 on Fri Apr 12, 2019 4:18 pm, edited 1 time in total.
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

EfficientInvestor
Posts: 280
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Indexing on leverage?

Post by EfficientInvestor » Fri Apr 12, 2019 3:11 pm

pdavi21 wrote:
Fri Apr 12, 2019 2:38 pm
EDIT: Which leveraged fund is okay for the OP to invest in, and how much of your own money have you invested in it?
Perhaps a 35/65 blend of a 2x stock and 2x 7-10 year treasury bond? I prefer SSO and UST, respectively. The backtest below substitutes DXKLX for UST because it has been around longer.

https://www.portfoliovisualizer.com/bac ... tion2_1=65

pdavi21
Posts: 1296
Joined: Sat Jan 30, 2016 4:04 pm

Re: Indexing on leverage?

Post by pdavi21 » Fri Apr 12, 2019 3:26 pm

............
Last edited by pdavi21 on Fri Apr 12, 2019 4:17 pm, edited 4 times in total.
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

Patzer
Posts: 202
Joined: Wed Jun 10, 2015 10:56 am

Re: Indexing on leverage?

Post by Patzer » Fri Apr 12, 2019 3:28 pm

alex123711 wrote:
Thu Apr 11, 2019 2:39 am
What's the general consensus of doing this? Since over the long term the index should go up wouldn't it be better to buy more using leverage? Is it that much different to buying a house with a mortgage.. (apart from possible margin calls)
From my IPS:
Never buy on Margin (Refer to USA 1929, Japan 1990, USA 2008, China 2015 if tempted)

DonIce
Posts: 882
Joined: Thu Feb 21, 2019 6:44 pm

Re: Indexing on leverage?

Post by DonIce » Fri Apr 12, 2019 5:50 pm

EfficientInvestor wrote:
Fri Apr 12, 2019 3:11 pm
Perhaps a 35/65 blend of a 2x stock and 2x 7-10 year treasury bond? I prefer SSO and UST, respectively. The backtest below substitutes DXKLX for UST because it has been around longer.
So about 70/130 equity/bonds.

I'm doing a similar strategy but at around 100/200, where the 200 is through 10 year treasury futures. See my thread here:
viewtopic.php?t=273666

Just started this strategy about a month ago so we'll see how it goes!

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