On Leverage

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pezblanco
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Re: On Leverage

Post by pezblanco » Tue Feb 26, 2019 11:59 am

alex_686 wrote:
Tue Feb 26, 2019 10:34 am
A couple of points.

I do think that a mortgage can beats out short term lending with leverage, even with the higher rates. It is a non-callable loan. Its long term, so rates are locked so you reduce duration risk. If it is tax deductible, that is a bonus. You would probably need to stretch into corporate bonds instead of treasuries.

Futures probably beat options. There have been some good threads recently about using futures and risk parity. You lever up equity and long bonds, and pay for it with cash and shorting short bonds.

Both futures and options have short term rates built into their price, so no free ride there. Neither will give you access to dividends, but so what? That is also factored in the price. If you are concerned about underperformance due to the missing dividends, just crank up the leverage. In for a penny, in by a pound. The problem with options is that you have to pay for both time and volatility.
I never did understand why options/futures make sense for leveraging up Bond funds. They by definition don't include the dividends (the coupons coming in from the bonds held) so what exactly are you hoping to increase in value? Are you hoping that interest rates will decline and give you a capital gain? That starts seeming like too much speculation instead of leveraged investment. At least with options/futures on a stock fund, you don't really need dividends to expect a long term rise in prices ... what am I missing here?

EfficientInvestor
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Re: On Leverage

Post by EfficientInvestor » Tue Feb 26, 2019 12:30 pm

pezblanco wrote:
Tue Feb 26, 2019 11:59 am
I never did understand why options/futures make sense for leveraging up Bond funds. They by definition don't include the dividends (the coupons coming in from the bonds held) so what exactly are you hoping to increase in value? Are you hoping that interest rates will decline and give you a capital gain? That starts seeming like too much speculation instead of leveraged investment. At least with options/futures on a stock fund, you don't really need dividends to expect a long term rise in prices ... what am I missing here?
You still indirectly receive the benefit of the dividend yield in the futures contract because it is credited towards you via a discount in the futures price.

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Re: On Leverage

Post by alex_686 » Tue Feb 26, 2019 12:41 pm

EfficientInvestor wrote:
Tue Feb 26, 2019 12:30 pm
You still indirectly receive the benefit of the dividend yield in the futures contract because it is credited towards you via a discount in the futures price.
It depends on what the underlying asset is and how the futures contract works, but this is true for the mostly popularly traded contracts. This is also mostly true for bond futures, but the math is a bit more complex.

You tend not to get dividends and bond yields on the popular option contacts - but once again it depends.

Edit - not trying to confuse or make things more complicated then they are. But for the futures contracts talked about in the other threads about leveraging the S&P 500, 10 year treasury, and 2 year treasury - you get the yield.

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Re: On Leverage

Post by EfficientInvestor » Tue Feb 26, 2019 5:26 pm

grayfox wrote:
Tue Feb 26, 2019 8:14 am
Interactive Brokers Interest Schedule shows USD Benchmark = 2.400% and the margin rate is
0 - 100K: BM + 1.5%
100K - 1M: BM + 1%
1M - 3M 2.9%: BM + 0.5%
3M - 200M 2.7%: BM + 0.3%
Edit: I realized I misspoke about margin requirements. Reg T allows you to borrow 50% of a stock purchase. So, in effect, you could develop a 2x portfolio based on Reg T requirements. This example will remain as a 1.5X portfolio.
https://www.interactivebrokers.com/en/i ... p?f=1232#1


I think one of the easiest ways for anyone to apply the leveraged strategy would be to open up a margin account with IB and trade using the rates shown above. Margin rules will limit you to borrowing up to 100% of your portfolio value. Let's assume that you would create a 1.5X fund through the use of portfolio margin. For the first 1X, you don't have to pay any interest, because those are your funds. So you are only paying the interest on 1/3 of your funds. So an effective margin rate for the first bracket, using a 1.5X, would just be 0.5% of total invested (not including the risk-free borrow rate).

Now, let's do a simple backtest to see how a 1.5x 40/60 stock/bond portfolio would have performed using these borrowing rates. The backtest below has 60% in S&P 500, 90% in long term treasury, and -50% in Cash (represents borrowing at the risk-free rate). Then, a withdrawal of 0.5% annually is applied to represent the margin needed on the portion borrowed.

https://www.portfoliovisualizer.com/bac ... ion3_1=-50

In comparison, below is a backtest of a selection of unleveraged asset allocations over the same time period ranging from 40/60 to 100/0.

https://www.portfoliovisualizer.com/bac ... tion2_3=20

Here is a summary of all backtests:

Jan 1987 - Jan 2019
1.5X 40/60 - CAGR = 11.1%, SD = 11.9%, Max DD = -23.1%
40/60 - CAGR = 9.0%, SD = 8.0%, Max DD = -14.5%
60/40 - CAGR = 9.5%, SD = 9.4%, Max DD = -27.0%
80/20 - CAGR = 9.9%, SD = 11.8%, Max DD = -39.3%
100/0 - CAGR - 10.1%, SD = 14.8%, Max DD = -51.0%

The 1.5X 40/60 fund would have outperformed the stock market over the time period with less max drawdown than a standard 60/40 fund. I don't think we can expect the same 11.1% CAGR for this portfolio in the near future, but it is hard for me to believe that this portfolio won't continue to deliver better risk-adjusted returns than being anywhere between 80/20 and 100/0.
Last edited by EfficientInvestor on Tue Feb 26, 2019 11:02 pm, edited 1 time in total.

HEDGEFUNDIE
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Re: On Leverage

Post by HEDGEFUNDIE » Tue Feb 26, 2019 6:14 pm

EfficientInvestor wrote:
Tue Feb 26, 2019 5:26 pm
grayfox wrote:
Tue Feb 26, 2019 8:14 am
Interactive Brokers Interest Schedule shows USD Benchmark = 2.400% and the margin rate is
0 - 100K: BM + 1.5%
100K - 1M: BM + 1%
1M - 3M 2.9%: BM + 0.5%
3M - 200M 2.7%: BM + 0.3%
I think one of the easiest ways for anyone to apply the leveraged strategy would be to open up a margin account with IB and trade using the rates shown above. Margin rules will limit you to borrowing up to 50% of your portfolio value, so let's assume that you would create a 1.5X fund through the use of portfolio margin. For the first 1X, you don't have to pay any interest, because those are your funds. So you are only paying the interest on 1/3 of your funds. So an effective margin rate for the first bracket, using a 1.5X, would just be 0.5% of total invested (not including the risk-free borrow rate).

Now, let's do a simple backtest to see how a 1.5x 40/60 stock/bond portfolio would have performed using these borrowing rates. The backtest below has 60% in S&P 500, 90% in long term treasury, and -50% in Cash (represents borrowing at the risk-free rate). Then, a withdrawal of 0.5% annually is applied to represent the margin needed on the portion borrowed.

https://www.portfoliovisualizer.com/bac ... ion3_1=-50

In comparison, below is a backtest of a selection of unleveraged asset allocations over the same time period ranging from 40/60 to 100/0.

https://www.portfoliovisualizer.com/bac ... tion2_3=20

Here is a summary of all backtests:

Jan 1987 - Jan 2019
1.5X 40/60 - CAGR = 11.1%, SD = 11.9%, Max DD = -23.1%
40/60 - CAGR = 9.0%, SD = 8.0%, Max DD = -14.5%
60/40 - CAGR = 9.5%, SD = 9.4%, Max DD = -27.0%
80/20 - CAGR = 9.9%, SD = 11.8%, Max DD = -39.3%
100/0 - CAGR - 10.1%, SD = 14.8%, Max DD = -51.0%

The 1.5X 40/60 fund would have outperformed the stock market over the time period with less max drawdown than a standard 60/40 fund. I don't think we can expect the same 11.1% CAGR for this portfolio in the near future, but it is hard for me to believe that this portfolio won't continue to deliver better risk-adjusted returns than being anywhere between 80/20 and 100/0.
Is the 0.5% actually applied to the “amount borrowed”? I thought the borrowing interest rate is implicit in the futures contract price?

EfficientInvestor
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Re: On Leverage

Post by EfficientInvestor » Tue Feb 26, 2019 8:32 pm

HEDGEFUNDIE wrote:
Tue Feb 26, 2019 6:14 pm
EfficientInvestor wrote:
Tue Feb 26, 2019 5:26 pm
grayfox wrote:
Tue Feb 26, 2019 8:14 am
Interactive Brokers Interest Schedule shows USD Benchmark = 2.400% and the margin rate is
0 - 100K: BM + 1.5%
100K - 1M: BM + 1%
1M - 3M 2.9%: BM + 0.5%
3M - 200M 2.7%: BM + 0.3%
I think one of the easiest ways for anyone to apply the leveraged strategy would be to open up a margin account with IB and trade using the rates shown above. Margin rules will limit you to borrowing up to 50% of your portfolio value, so let's assume that you would create a 1.5X fund through the use of portfolio margin. For the first 1X, you don't have to pay any interest, because those are your funds. So you are only paying the interest on 1/3 of your funds. So an effective margin rate for the first bracket, using a 1.5X, would just be 0.5% of total invested (not including the risk-free borrow rate).

Now, let's do a simple backtest to see how a 1.5x 40/60 stock/bond portfolio would have performed using these borrowing rates. The backtest below has 60% in S&P 500, 90% in long term treasury, and -50% in Cash (represents borrowing at the risk-free rate). Then, a withdrawal of 0.5% annually is applied to represent the margin needed on the portion borrowed.

https://www.portfoliovisualizer.com/bac ... ion3_1=-50

In comparison, below is a backtest of a selection of unleveraged asset allocations over the same time period ranging from 40/60 to 100/0.

https://www.portfoliovisualizer.com/bac ... tion2_3=20

Here is a summary of all backtests:

Jan 1987 - Jan 2019
1.5X 40/60 - CAGR = 11.1%, SD = 11.9%, Max DD = -23.1%
40/60 - CAGR = 9.0%, SD = 8.0%, Max DD = -14.5%
60/40 - CAGR = 9.5%, SD = 9.4%, Max DD = -27.0%
80/20 - CAGR = 9.9%, SD = 11.8%, Max DD = -39.3%
100/0 - CAGR - 10.1%, SD = 14.8%, Max DD = -51.0%

The 1.5X 40/60 fund would have outperformed the stock market over the time period with less max drawdown than a standard 60/40 fund. I don't think we can expect the same 11.1% CAGR for this portfolio in the near future, but it is hard for me to believe that this portfolio won't continue to deliver better risk-adjusted returns than being anywhere between 80/20 and 100/0.
Is the 0.5% actually applied to the “amount borrowed”? I thought the borrowing interest rate is implicit in the futures contract price?
The intent of the post was to highlight the costs associated with using portfolio margin from Interactive Brokers, which seems to have the cheapest portfolio margin rates available. The example is not trying to represent the use of futures in any way. It represents buying index funds directly but using the maximum amount of portfolio margin allowed (50% of available funds). Hence the 1.5X portfolio. The 1.5% margin rate and the risk-free borrowing rate would both be applied to the amount borrowed. In this case, 2/3 of the invested funds would be your money and 1/3 would be borrowed. In the backtest, the margin rate is represented by the 0.5%/year (1/3 of fund times 1.5% margin rate) that is withdrawn from the account. The -50% CASHX represents 1/3 of the account (of the 150%) that is borrowing at the risk-free rate.

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privatefarmer
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Re: On Leverage

Post by privatefarmer » Wed Feb 27, 2019 5:15 am

the elephant in the room is that IBs borrowing rates are VARIABLE, tied to the fed-fund rate. and if you look back at history the fed fund rate can rise dramatically quick. So this all may work if rates stay low or only GRADUALLY rise in a way that you can manage. but if they quickly shoot up AND the market takes a hit, then you either sell at a loss or your borrowing costs go way up.

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grayfox
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Re: On Leverage

Post by grayfox » Wed Feb 27, 2019 8:02 am

privatefarmer wrote:
Wed Feb 27, 2019 5:15 am
the elephant in the room is that IBs borrowing rates are VARIABLE, tied to the fed-fund rate. and if you look back at history the fed fund rate can rise dramatically quick. So this all may work if rates stay low or only GRADUALLY rise in a way that you can manage. but if they quickly shoot up AND the market takes a hit, then you either sell at a loss or your borrowing costs go way up.
That's why I originally was favoring something like a 15 or 30-year fixed-rate mortgage loan. That way the terms and rate are cast in concrete and they can't pull the rug out from under you.

longinvest
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Re: On Leverage

Post by longinvest » Wed Feb 27, 2019 8:13 am

grayfox wrote:
Wed Feb 27, 2019 8:02 am
That's why I originally was favoring something like a 15 or 30-year fixed-rate mortgage loan. That way the terms and rate are cast in concrete and they can't pull the rug out from under you.
Unfortunately, the mortgage leverages the real estate investment, not the portfolio, as I explained earlier in this thread.

It would be nice if banks started writing low fixed-rate 30-year mortgages against stock and bond investments. But, I don't think that it's going to happen any time soon. :wink:
Bogleheads investment philosophy | One-ETF global balanced index portfolio | VPW

msk
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Re: On Leverage

Post by msk » Wed Feb 27, 2019 8:16 am

How to amplify your gains WITHOUT leverage.

Premise: you are "happy" to get 6% annual capital appreciation on the SP500 and happy to forego gains beyond that.
6% gain on the SP500 will put it at 3000 one year hence. You will also receive about 1.5% in dividends
Sell Call options on SPY with a strike at 300 (=3000 SP500) for $7.7 (i.e. receive 2.6% premium) maturing March 20, 2020

Instead of your being happy with only 6%+1.5% by March 2020 you will end up with 6%+1.5%+2.6% (=10.1%). IMHO this is far better than leveraging because you DECREASE your exposure to a downwards market movement, by 2.6%, compared to just holding your SPY steady. And no need to worry about arithmetic and probabilities. There are plenty of quants employed to make sure that Calls are priced appropriately. That's the only catch. You are betting that these very clever rocket scientists have mispriced the Calls :annoyed

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grayfox
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Re: On Leverage

Post by grayfox » Wed Feb 27, 2019 8:31 am

EfficientInvestor wrote:
Tue Feb 26, 2019 5:26 pm
Now, let's do a simple backtest to see how a 1.5x 40/60 stock/bond portfolio would have performed using these borrowing rates. The backtest below has 60% in S&P 500, 90% in long term treasury, and -50% in Cash (represents borrowing at the risk-free rate). Then, a withdrawal of 0.5% annually is applied to represent the margin needed on the portion borrowed.

https://www.portfoliovisualizer.com/bac ... ion3_1=-50

In comparison, below is a backtest of a selection of unleveraged asset allocations over the same time period ranging from 40/60 to 100/0.

https://www.portfoliovisualizer.com/bac ... tion2_3=20

Here is a summary of all backtests:

Jan 1987 - Jan 2019
1.5X 40/60 - CAGR = 11.1%, SD = 11.9%, Max DD = -23.1%
40/60 - CAGR = 9.0%, SD = 8.0%, Max DD = -14.5%
60/40 - CAGR = 9.5%, SD = 9.4%, Max DD = -27.0%
80/20 - CAGR = 9.9%, SD = 11.8%, Max DD = -39.3%
100/0 - CAGR - 10.1%, SD = 14.8%, Max DD = -51.0%

The 1.5X 40/60 fund would have outperformed the stock market over the time period with less max drawdown than a standard 60/40 fund. I don't think we can expect the same 11.1% CAGR for this portfolio in the near future, but it is hard for me to believe that this portfolio won't continue to deliver better risk-adjusted returns than being anywhere between 80/20 and 100/0.
Underlined clause: That's the problem with backtesting. It's looking in the rear-view mirror. That's the same reason it's not worthwhile finding MPT optimum portfolios using past data. As a theory, MPT is great. But you find that the optimum weights change with every period. So useless in practice.

The same with leveraged trades. It boils down to 1) what rate you can borrow at today, 2) what the expected return of the investment is over the future period and 3) what volatility is expected over the future period. Then decide what amount of profit you require to make it worth considering. Interest rates, expected returns and variances, etc. are constantly changing. You would have to forecast these things at a point in time to make a decision.
Last edited by grayfox on Wed Feb 27, 2019 8:54 am, edited 1 time in total.

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Re: On Leverage

Post by grayfox » Wed Feb 27, 2019 8:53 am

Following with example. Based on current interest rates and stock valuations, I estimated that 40/60 VFINX/VUSTX has Expected Return = 3.88% before inflation. If I borrowed from IB at 2.40 + 1.00 = 3.40% ($100K minimum), the difference is +48 basis points of expected profit in the leveraged trades. Historically for 40/60, STD Dev was 8% and Max DD was -14.5%.

Is +48 bsp enough profit given the volatility, Max DD and risk? Based on my gut instinct, I would require something like 200 - 250 bsp to consider taking on that risk. For me, at +48 bsp, the profit is too slim for the amount of risk. Rule 62: The risker the road, the greater the profit required.

Other investors can have their own forecasts and profit requirements. Every investor should form his own opinion.

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Re: On Leverage

Post by EfficientInvestor » Wed Feb 27, 2019 9:59 am

grayfox wrote:
Wed Feb 27, 2019 8:53 am
Following with example. Based on current interest rates and stock valuations, I estimated that 40/60 VFINX/VUSTX has Expected Return = 3.88% before inflation. If I borrowed from IB at 2.40 + 1.00 = 3.40% ($100K minimum), the difference is +48 basis points of expected profit in the leveraged trades. Historically for 40/60, STD Dev was 8% and Max DD was -14.5%.

Is +48 bsp enough profit given the volatility, Max DD and risk? Based on my gut instinct, I would require something like 200 - 250 bsp to consider taking on that risk. For me, at +48 bsp, the profit is too slim for the amount of risk. Rule 62: The risker the road, the greater the profit required.

Other investors can have their own forecasts and profit requirements. Every investor should form his own opinion.
Edit: My calcs for the leveraged portion were wrong in initial post. Updates are below.

I agree that it's much harder to pull the trigger on the concept with the limited spread. I can't remember the expected returns you previously posted for stocks and bonds, but I'm going to assume 6% and 2.5%, respectively. If that's the case, below are expected returns of various unleveraged portfolios along with historical SD and Max DD since 1987:

40/60 - Expected Return = 3.9%, SD = 8.0%, Max DD = -14.5%
60/40 - Expected Return = 4.6%, SD = 9.4%, Max DD = -27.0%
80/20 - Expected Return = 5.3%, SD = 11.8%, Max DD = -39.3%
100/0 - Expected Return = 6.0%, SD = 14.8%, Max DD = -51.0%

Here are some expected returns of leveraged 40/60 funds using the 3.4% IB rate for accounts over $100k. The borrow rate is applied to any funds above the 1X. In the case of the 2X portfolio, the borrow rate would only be applied to half of the invested funds. Therefore, the 2X 40/60 expected return = 3.9 + (3.9 - 3.4) = 4.4.

1.5X 40/60 - Return = 4.15%, SD = 11.9%, Max DD = -23.1%
2X 40/60 - Return = 4.4%, SD = 15.8%, Max DD = -30.6%

alex_686
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Re: On Leverage

Post by alex_686 » Wed Feb 27, 2019 12:16 pm

longinvest wrote:
Wed Feb 27, 2019 8:13 am
Unfortunately, the mortgage leverages the real estate investment, not the portfolio, as I explained earlier in this thread.

It would be nice if banks started writing low fixed-rate 30-year mortgages against stock and bond investments. But, I don't think that it's going to happen any time soon. :wink:
Fortunately, the mortgage leverages the portfolio. As explained earlier in this thread, this is a example of mental accounting and should be avoided.

Quick exmaple:

Case 1: Investor has
200k property
100k mortgage
200k stock equities

Case 2: Investor has
200k property
200k stock equities
100k margin loan

Case 3: Investor has
200k property
100k, stock equities.

All have a net worth of 300k. Now, explain how the net worth of Case 1 & 2 will differ after 10 years? You can't - mathematically they will return the same results. Any difference not be from the leverage, but from the type of leverage. That is, mortgages tend to have a higher rate, are non-callable, are harder to rebalance, etc.

stoxtrader
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Re: On Leverage

Post by stoxtrader » Wed Feb 27, 2019 12:31 pm

msk wrote:
Wed Feb 27, 2019 8:16 am
How to amplify your gains WITHOUT leverage.

Premise: you are "happy" to get 6% annual capital appreciation on the SP500 and happy to forego gains beyond that.
6% gain on the SP500 will put it at 3000 one year hence. You will also receive about 1.5% in dividends
Sell Call options on SPY with a strike at 300 (=3000 SP500) for $7.7 (i.e. receive 2.6% premium) maturing March 20, 2020

Instead of your being happy with only 6%+1.5% by March 2020 you will end up with 6%+1.5%+2.6% (=10.1%). IMHO this is far better than leveraging because you DECREASE your exposure to a downwards market movement, by 2.6%, compared to just holding your SPY steady. And no need to worry about arithmetic and probabilities. There are plenty of quants employed to make sure that Calls are priced appropriately. That's the only catch. You are betting that these very clever rocket scientists have mispriced the Calls :annoyed
sounds somewhat reasonable but you must remember this is relatively tax inefficient.

longinvest
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Re: On Leverage

Post by longinvest » Wed Feb 27, 2019 12:58 pm

alex_686 wrote:
Wed Feb 27, 2019 12:16 pm
longinvest wrote:
Wed Feb 27, 2019 8:13 am
Unfortunately, the mortgage leverages the real estate investment, not the portfolio, as I explained earlier in this thread.

It would be nice if banks started writing low fixed-rate 30-year mortgages against stock and bond investments. But, I don't think that it's going to happen any time soon. :wink:
Fortunately, the mortgage leverages the portfolio. As explained earlier in this thread, this is a example of mental accounting and should be avoided.

Quick exmaple:

Case 1: Investor has
200k property
100k mortgage
200k stock equities

Case 2: Investor has
200k property
200k stock equities
100k margin loan

Case 3: Investor has
200k property
100k, stock equities.

All have a net worth of 300k. Now, explain how the net worth of Case 1 & 2 will differ after 10 years? You can't - mathematically they will return the same results. Any difference not be from the leverage, but from the type of leverage. That is, mortgages tend to have a higher rate, are non-callable, are harder to rebalance, etc.
Dear Alex,

The net worth will obviously differ between Cases 1 and 2 after 10 years because the terms of the loans differ. The interest rates will differ (the margin has a floating rate), and the lender might issue a margin call in Case 2.

Best regards,

longinvest
Bogleheads investment philosophy | One-ETF global balanced index portfolio | VPW

longinvest
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Re: On Leverage

Post by longinvest » Wed Feb 27, 2019 1:20 pm

Let's pick a better example.

Two investors have identical salaries.

Investor 1 has a 100K portfolio. He buys a 200K house borrowing 160K from the bank and 40K from family.

Investor 2 has a 100K portfolio and rents.

Both invest their portfolio identically.

After 10 years, the difference in outcome is entirely due to the difference between the cost of renting and the net gain or loss (considering all expenses, including repairs, taxes, interest, etc.) on the leveraged real estate investment. No difference will be due to the portfolios.

Investor 1's loan doesn't leverage his portfolio; it obviously leverages his house investment.
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alex_686
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Re: On Leverage

Post by alex_686 » Wed Feb 27, 2019 2:17 pm

longinvest wrote:
Wed Feb 27, 2019 1:20 pm
Let's pick a better example.
Why is your example better? We are no longer comparing apples to apples.
longinvest wrote:
Wed Feb 27, 2019 1:20 pm
Investor 1's loan doesn't leverage his portfolio; it obviously leverages his house investment.
In order for this to be true one would have to assume that property is not an asset - which I find really odd.

Let us try this:

Case 1:
Home: 200k
Mortgage: 200k
Equity: 100k
Pays immputed rent.

As an aside, may I ask why it matters if 40k is lent from the bank or from the family? 2nd mortgage or HELOC?

Case 2:
Rental Property: 200k
Mortgage: 200k
Equity: 100k
Pays Rents

Case 3:
Equity 100k.
Pays Rents
longinvest wrote:
Wed Feb 27, 2019 1:20 pm
Two investors have identical salaries. ... Both invest their portfolio identically.
Plus, we need to hold savings and consumption equal. Hence the imputed rent for Case #1: Now we can compare apples to apples.
longinvest wrote:
Wed Feb 27, 2019 1:20 pm
After 10 years, the difference in outcome is entirely due to the difference between the cost of renting and the net gain or loss (considering all expenses, including repairs, taxes, interest, etc.) on the leveraged real estate investment. No difference will be due to the portfolios.
I will agree with 90% of what you say. But most of the things you cite are tied to different levels of consumption and savings, not on where the leverage is in the portfolio.
longinvest wrote:
Wed Feb 27, 2019 1:20 pm
Investor 1's loan doesn't leverage his portfolio; it obviously leverages his house investment.
This is true only if you consider equity investments and property as 2 separate portfolios with 2 separate set of goals and risk tolerance. This is also a clear example of mental accounting.

longinvest
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Re: On Leverage

Post by longinvest » Wed Feb 27, 2019 5:21 pm

alex_686 wrote:
Wed Feb 27, 2019 2:17 pm
longinvest wrote:
Wed Feb 27, 2019 1:20 pm
Investor 1's loan doesn't leverage his portfolio; it obviously leverages his house investment.
This is true only if you consider equity investments and property as 2 separate portfolios with 2 separate set of goals and risk tolerance. This is also a clear example of mental accounting.
Dear Alex,

The mortgage's leverage is against the house. If Investor 1 fails to pay his mortgage, the bank won't be doing any mental accounting by foreclosing on the house.

We probably agree that Investor 1 is indebted and that his net worth includes the debt, the house, and the portfolio. We probably also agree that his personal risk profile includes all of this.

But, the leverage isn't against his salary, nor against his portfolio, but against his house. That's why the bank is loaning him money for such a long term at such a low rate. As long as Investor 1 keeps a mortgage (including a home equity line of credit, HELOC), he is exposed to foreclosure. By paying his mortgage, Investor 1 isn't reducing the risk of losing his portfolio but the risk of losing his house.

If Investor 2 (the renter) was to approach his bank and ask for a personal line of credit, he wouldn't get mortgage-like loan conditions. Likewise if he approaches his brokerage to get a margin account.

It isn't mental accounting to consider that the collateral that was provided to get the loan is the subject of the leverage.

Best regards,

longinvest
Bogleheads investment philosophy | One-ETF global balanced index portfolio | VPW

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grayfox
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Re: On Leverage

Post by grayfox » Thu Feb 28, 2019 1:05 pm

If I have to take my ship through pirate-infested space, it has to be worth my while. And we'll be carrying contraband and we'll be chased by Imperial cruisers? And dodging asteroids? It's going to cost you a pretty penny. :dollar 8-)

If you are going to take on risk, you need to be paid for it. What would have to change to make levering 40/60 worthwhile?

On the bond side, the yield curve is too flat. 1M yields 2.43 and 20Y yields 2.91. It needs to be steeper. If the 20Y was yielding 5%, it would improve things.

On the stock side, valuations are too high. CAPE = 30.51. With 2% inflation, that's about 5.3% expected return for S&P500. If CAPE was about 15, expected returns would be more like 8.6%. So the 40/60 would offer 6.60%. Then if you were to borrow from IB at 3.4% you would have 320 bsp profit. That would be worth considering.

:arrow: Yield curve is too flat and stock valuations are too high. This is a terrible time for leveraging stocks and bonds.

:idea: Wait for a better opportunity.

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Re: On Leverage

Post by msk » Thu Feb 28, 2019 10:08 pm

grayfox wrote:
Thu Feb 28, 2019 1:05 pm
:idea: Wait for a better opportunity.
Yes. I normally use options after a market drop of 30% or more from peak. Unfortunately(?!) the recent drop in 2018 did not go that deep. I was ready to use margin at IB to BUY Calls on SPY (actually the equivalent for All World, ACWI is my preferred play area) but the markets went down only 20% and did not fathom my 30% trigger depth :mrgreen:

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Re: On Leverage

Post by grayfox » Fri Mar 01, 2019 8:25 am

Not waiting for a good deal is a bad idea. One lesson I learned about risk and reward was from the casinos.

A long time ago,I read a book about casino games by a guy named John Scarne. He was an expert on all kinds of games of chance. The thing he said was that it was not the loser who paid for the casino, but the winner. The loser bets $1 and loses $1. He gets a fair deal. Meanwhile the winner bets $1 and wins $1. But based on the odds, he should have won $1.02, if it was a fair game. So each $1 bet was only worth about 98 cents, on average. Paying $1 for 98 cents of value, in the long run his pile will get smaller and smaller.

Now for the 40/60 leverage case reference above, there was a positive profit of +48 basis points. In theory, you should be able to leverage that slim margin up and make big money. But if you have a string of bad luck, you can be ruined before you make the big money. You want the chance of ruin to be very small.

I'm sure there must be some maths that can calculate your chance of ruin for any profit margin. You would choose a chance of ruin based on you personal risk preference -- 10%, 5%, 1%, .1%. Then, from the probability distribution of the investment and the amount of leverage, calculate how much profit margin is required.

I tried to make up a table for myself. I didn't do any maths, this is just my gut instinct.

Code: Select all

Volatility (%) Max DD (%)  Required Profit (bsp)
    0           0                10
   2.5         7.5              100
    5          15               200     <- Wellesley
   7.5        22.5              250 
   10          30               300
   15          45               400     <- S&P500
   20          60               500     <- Emerging Markets
   25          75               600
   30          90              1000
E.g. S&P 500, which has had about 15% SD and about -50% Max DD, I would require something greater than +400 basis points profit. Less than that, Fuhgeddaboudit!

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Re: On Leverage

Post by acegolfer » Fri Mar 01, 2019 11:06 am

Correct.

1. Leverage is how corporations/banks make bigger profits than without.
2. Perhaps, people don't understand this. On a weighted scale, half of stock investments are invested with borrowed money. Picture CML. At the market equilibrium (where aggregate net borrowing = 0), half are on the left side of M, the other half are on the right side (leveraged).

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Re: On Leverage

Post by grayfox » Sat Mar 02, 2019 8:42 am

I thought I would look at another point in time and apply my leverage decision methodology. This is going back to September 16, 2007 before the Great Recession of 2008. I choose that date because it was the date of the opening post of market timer's thread A different approach to asset allocation.

I mostly looked the numbers up on FRED. CAPE from multiple.com. I show the numbers next to Jan-2019 for comparison.

Code: Select all

                        Sep-2007        Jan-2019
1M LIBOR                5.12375%        2.50713%
1M LIBOR + 1%           6.124%          3.507%
30-YR FIXED MORTGAGE    6.38%           4.51%
20-YR TREAS             4.84%           2.89%
INFLATION EXP           2.47%           1.87%
CAPE                    26.73           28.70
1/CAPE                  3.74%           3.48%
VFINX E.R.              6.21%           5.35%
VUSTX E.R.              4.84%           2.89%
40/60 VFINX/VUSTX       5.39%           3.88%
SPREAD (bsp)            -73.53          36.86
In Sep-2007, before the financial crisis of 2008-2009, interests rates were much higher than today. Short-term rates were over 5%. That would have put margin costs at about 6%. Mortgage rates were just over 6%. 20-Year treasury was almost 5%. I recall buying a 6% PenFed CD about that time. Inflation expectations 2.47% were slightly higher than today.

CAPE at 26.73 was only slightly lower than Jan-2019. That plus higher inflation expectations put the expected return of S&P500 at nominal 6.21%, a bit better than today. But not much higher than PenFed 5-year CD at the time. :!:

E.R. of 40/60 was much higher than Jan-2019. 5.39 vs 3.88. So that's better. However, higher short-term interest rates make the borrowing cost higher than the expected return on the 40/60. The profit is negative, -73.53. That leveraged trade is rejected. :thumbsdown

:?: How about just leveraging the S&P500?
Expected Return = 6.21%. But if borrowing costs are 1M-LIBOR + 1% = 6.124, that gives only about 9 basis points of profit. My rule requires at least 400 bsp. So that trade is rejected as well. :thumbsdown

:arrow: September 2016 was another bad time to leverage your portfolio, mostly because short-term interest rates were high making borrowing costs too high to have enough profit. And stock valuations were high, as well, reducing expected return from stocks.

-------
About Expected Return of S&P500. I used 1/CAPE + inflation expectations to give nominal (before inflation) expected return of 6.21% on Sep-2007.

Back in 2007, I recall most BHs did not believe that expected return depended on valuation. The idea was that the S&P500 always had the same expected real return, which could be estimated using the historical average which was something like 6.7% real return. In academia this is called the Constant Expected Return (CER) Model. Since that time, the idea that expected return depends on valuation has become more widespread, although some still cling to the CER model.

I'm pretty sure that by 2007, I was already on board with the notion that E.R. depended on valuation. And what was I doing with my investments back then? Buying 6% PenFed CDs.
Last edited by grayfox on Sat Mar 02, 2019 10:10 am, edited 4 times in total.

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Re: On Leverage

Post by anil686 » Sat Mar 02, 2019 8:58 am

I found the most recent edition of Random Walk by Malkiel informative on both risk parity strategies and multi factor investing. His impression is with the low interest rates currently in the market place (in contrast to the early 1980s), such a risk parity strategy of leveraging treasury bonds may not work as robustly as it did in the past (that doesn’t mean it won’t work) but in his opinion high net worth investors may be able to diversify their risk exposure from just market beta by adding a multi factor etf to a total market portfolio. Hope that helps...

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Re: On Leverage

Post by grayfox » Sun Mar 03, 2019 7:10 am

In the previous post I considered leverage trade in Sep-2007, a point in time just before the financial crisis. It turned out to be a terrible time to leverage stocks and bonds. How about just after the financial crisis? I'll look at Jan-2010.

I compare before and after the financial crisis. Behold!

Code: Select all

                        Jan-2010        Sep-2007
                        After Crisis    Before Crisis           
1M LIBOR                0.23094%        5.12375%
1M LIBOR + 1%           1.231%          6.124%
30-YR FIXED MORTGAGE    5.14%           6.38%
20-YR TREAS             4.50%           4.84%
INFLATION EXP           2.63%           2.47%
CAPE                    20.53           26.73
1/CAPE                  4.87%           3.74%
VFINX E.R.              7.50%           6.21%
VUSTX E.R.              4.50%           4.84%
40/60 VFINX/VUSTX       5.70%           5.39%
SPREAD (bsp)            446.94          -73.53
When everything was hunky dory before the crisis, short-term interest rates were high, over 5%. After the crisis they were brought way down. If you borrowed at 1-Month LIBOR + 1% you paid only a little over 1%. Cheap money :!:

Meanwhile, LT Bonds were almost the same after as before the crisis. Stock valuations were lower, increasing expected return. Overall, the 40/60 had slightly higher expected return after than before the crisis.

But with such low short-term rates, profit margin on the leverage trade was very wide, +446 basis points. That's well above my criteria of at least 200-250 bsp. Jan-2010 would have been a good time to consider using leverage. :thumbsup

:idea: When someone will lend you money at about 1%, yeah it would make sense to borrow and invest in bonds yielding 4.5% or stocks returning 7.5%. :mrgreen:

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Re: On Leverage

Post by grayfox » Wed Mar 06, 2019 8:00 am

Here's an idea. You can borrow $100,000 at 3.4% from Interactive Brokers. Suppose you could arrange for a $100,000 3.4% interest-only loan. What if you invested in dividend stocks?

According to Yahoo Finance, Vanguard High Dividend Yield ETF (VYM) has a dividend yield of 3.00%. Foreign dividend stocks, Vanguard High Dividend Yield ETF (VYMI), have a higher yield, 3.95%.

Let's say you put $50,000 in VYM and $50,000 in VYMI. VYM would pay $1500 p.a. and VYMI would pay $1975 p.a. The whole portfolio would pay $3475 in dividends.

The annual interest on $100,000 @ 3.4% is $3400. Dividends would cover that with $75 left over. Positive cash flow. So it costs nothing to carry this. Plus the dividend should increase each year, increasing your positive cash flow.

This wouldn't require putting in anything at all. You start with $0.
Borrow $100,000 or $1,000,000 or $10,000,000 or $100,000,000 and pay the interest with the dividend.
It's all done with Other People's Money. ;-)
Last edited by grayfox on Wed Mar 06, 2019 8:50 am, edited 2 times in total.

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Re: On Leverage

Post by acegolfer » Wed Mar 06, 2019 8:12 am

grayfox wrote:
Wed Mar 06, 2019 8:00 am
Here's an idea. You can borrow $100,000 at 3.4% from Interactive Brokers. Suppose you could arrange for a $100,000 3.4% interest-only loan. What if you invested in dividend stocks?

According to Yahoo Finance, Vanguard High Dividend Yield ETF (VYM) has a dividend yield of 3.00%. Foreign dividend stocks, Vanguard High Dividend Yield ETF (VYM), have a higher yield, 3.95%.

Let's say you put $50,000 in VYM and $50,000 in VYMI. VYM would pay $1500 p.a. and VYMI would pay $1975 p.a. The whole portfolio would pay $3475 in dividends.

The annual interest on $100,000 @ 3.4% is $3400. Dividends would cover that with $75 left over. Positive cash flow. So it costs nothing to carry this. Plus the dividend should increase each year, increasing your positive cash flow.

This wouldn't require putting in anything at all. Just borrow $100,000 or $1,000,000 or $10,000,000 or $100,000,000 and pay the interest with the dividend.
Note, the yield is not a guaranteed return.

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Re: On Leverage

Post by grayfox » Wed Mar 06, 2019 8:37 am

acegolfer wrote:
Wed Mar 06, 2019 8:12 am

Note, the yield is not a guaranteed return.
I think the big risk is that the dividend gets cut and it doesn't cover the interest payment. Then you would have to make up the difference or liquidate. So there is a risk of ruin. Maybe this can be done inside a Limited Liability Corporation?

I know that a lot of dividends were cut during the financial crisis 2009. Dividend stock funds like iShares Select Dividend ETF DVY cut something like -25%. DVY Dividend History.

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Re: On Leverage

Post by grayfox » Thu Mar 07, 2019 7:30 am

OK, I thought I would try out this idea. I'll borrow $10,000 and use the money to buy VYMI which has 3.95% dividend yield. I'll pay the lender 3.9% p.a. interest, $390 per year or $32.50 per month. The lender can hold the stock as collateral. If it works out, maybe I'll scale it up to $100,000 and if that works out , maybe $1,000,000.

So I went over to the IB website. They have a Margin Eduaction Center that explains how margin account works. There are all kinds of complicated definitions and calculations - initial margin, maintenance margin, Equity with Loan Value, Reg T Margin. There are time of trade margin calculations, real-time margin calculations, overnight margin calculations and on and on. Very difficult to understand it all.

Then they have an example, Customer deposits $10,000 cash in a margin account. Then customer buys $20,000 worth of stock. $10,000 with your own money and $10,000 with their money.

What ?!? I want to borrow $10,000, not give them $10,000.
In order to borrow $10,000, I have to give them $10,000 ?!? :?

I just want to borrow $10,000 to buy $10,000 worth of stock. Not $20,000 worth of stock. Assuming I have $10,000, I would prefer to keep it in a MMF yielding 2.5% or a CD yielding 3%.

So if I want to borrow $1 million, I would have to first give them $1 million ?!?
They are getting paid the interest. They have the stock as collateral. If I stop paying interest they can foreclose and take the stock.

Why should I have to buy twice as much stock as I want for them to lend the money?
That's like if I wanted to buy an F-150 pickup, the dealer would lend me $40,000 to buy a second F-150, but only after I bought the first F-150 with my own $40,000 cash.

:arrow: Maybe I am misunderstanding how margin accounts work, but it sounds like they only lend you money if you already have the money and give it to them. If that's how it works, no thanks.

BTW, I did not even get to the part where they start liquidating your position. So it's even worse.
Last edited by grayfox on Thu Mar 07, 2019 7:56 am, edited 1 time in total.

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Re: On Leverage

Post by EfficientInvestor » Thu Mar 07, 2019 7:56 am

grayfox wrote:
Thu Mar 07, 2019 7:30 am
OK, I thought I would try out this idea. I'll borrow $10,000 and use the money to buy VYMI which has 3.95% dividend yield. I'll pay the lender 3.9% p.a. interest, $390 per year or $32.50 per month. The lender can hold the stock as collateral. If it works out, maybe I'll scale it up to $100,000 and if that works out , maybe $1,000,000.

So I went over to the IB website. They have a Margin Eduaction Center that explains how margin account works. There are all kinds of complicated definitions and calculations - initial margin, maintenance margin, Equity with Loan Value, Reg T Margin. There are time of trade margin calculations, real-time margin calculations, overnight margin calculations and on and on. Very difficult to understand it all.

Then they have an example, Customer deposits $10,000 cash in a margin account. Then customer buys $20,000 worth of stock. $10,000 with your own money and $10,000 with their money.

What ?!? I want to borrow $10,000, not give them $10,000.
In order to borrow $10,000, I have to give them $10,000 ?!? :?

I just want to borrow $10,000 to buy $10,000 worth of stock. Not $20,000 worth of stock. Assuming I have $10,000, I would prefer to keep it in a MMF yielding 2.5% or a CD yielding 3%.

So if I want to borrow $1 million, I would have to first give them $1 million ?!?
They are getting paid the interest. They have the stock as collateral. If I stop paying interest they can foreclose and take the stock.

Why should I have to buy twice as much stock as I want for them to lend the money?
That's like if I wanted to buy an F-150 pickup, the dealer would lend me $40,000 to buy a second F-150, but only after I bought the first F-150 with my own $40,000 cash.

:arrow: Maybe I am misunderstanding how margin accounts work, but it sounds like they only lend you money if you already have the money and give it to them. If that's how it works, no thanks.
Without the margin requirements, you never would have access to such low borrowing rates. The reason they can offer such low rates is because the margin rules effectively guarantee that there is always enough value in your positions to cover their loaned amount. That way, if you don’t put in more money when there is a margin call, they can liquidate all holdings and put the amount they loaned you back in their pockets.

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Re: On Leverage

Post by grayfox » Thu Mar 07, 2019 8:03 am

EfficientInvestor wrote:
Thu Mar 07, 2019 7:56 am

Without the margin requirements, you never would have access to such low borrowing rates. The reason they can offer such low rates is because the margin rules effectively guarantee that there is always enough value in your positions to cover their loaned amount. That way, if you don’t put in more money when there is a margin call, they can liquidate all holdings and put the amount they loaned you back in their pockets.
This sounds like a Win-Win...for the broker. Stock goes up, they collect interest and win. Stock goes down, they sell your position at a loss to you and they win again.

For the investor, not so much. All the loan terms are in favor of the broker.

What I would want is to borrow $10,000 let's say for a period of 5 or 10 or 30 years as an amortizing loan like a mortgage. Every month you pay interest plus some principle, the loan is paid off at the end of the term, and you own the stock free and clear. I would be willing to put down something like 10% or 20%.

But the way they have margin loans structured, I would not take it.

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Re: On Leverage

Post by alex_686 » Thu Mar 07, 2019 10:17 am

grayfox wrote:
Thu Mar 07, 2019 8:03 am
This sounds like a Win-Win...for the broker. Stock goes up, they collect interest and win. Stock goes down, they sell your position at a loss to you and they win again.

But the way they have margin loans structured, I would not take it.
Let me give you a little context on this. I used to work the margin desk at a broker during the dot.com boom and bust. A familiar pattern is that a client borrows a large amount of money from the broker, the collateral's value falls below the loan value, this causes the broker to go bankrupt, causing all of the broker's clients to lose their assets.

This does not happen anymore. One of the reasons are changes made to how margin is handled after the 1929 crash. Brokers must protect their brokerage first, before their client's interest. You know all the rules you have read about margin? In times of stress the brokerage can toss them out and do what you want. They are given a very wide latitude - and correctly, I think.

But if not a margin loan, then what? One of the reasons why margin rates are so low is that they are fully collateralize, the broker holds the assets, and it can be liquidated at any time. From a lending preservative it is about as safe as you can get. You need to find another very safe loan - safe from the lender's prescriptive, not yours. Which takes us back to mortgage loans.

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Re: On Leverage

Post by grayfox » Thu Mar 07, 2019 2:08 pm

This sounds like it could be joke. Like an Abbot and Costello comedy routine. I remember one routine where Abbot asks to borrow some money:

Abbot: Hey, Costello. Lend me a dollar.
Costello: I don't have a dollar. I only have 50 cents.
Abbot: OK, then, give me the 50 cents and you can owe me 50 cents.


This situation is more like:

Costello: Hey, Abbot, lend me $10.
Abbot: OK, I'll lend you $10. But first give me $10 to hold as collateral.


Fast-talking Abbot always took advantage of the poor sap Costello.

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Re: On Leverage

Post by grayfox » Fri Mar 08, 2019 7:04 am

I have come full circle and I am back to my original thought that the most important thing is the terms of the loan. Margin accounts are so one-sided they could be a comedy joke. Mortgage would work (ok, it's actually leveraging the house), but the rate is high.

The best idea I've heard so far is to borrow from a family member. But I would pay it off like a mortage. Here's the idea.

A 60-year-old retired family member has assets and needs income. A 20-year-old family member wants to invest in stocks, but has no money. However he graduated from high school and has a steady job. Old could put $10,000 in a 3.0% 5-year CD. Instead lends to Young at 3.4% for 10 years. From mortgage calculator, that would be $98.42 per month income for Old. That is higher than what a 10-year annuity would pay which is $93.10.

Young invests in 50/50 VYM/VYMI which yields $150 + $197.50 = $347.50 per year, or $28.95 per month. He would have to make up the difference, $69.46 per month from his paycheck.

:arrow: Old gets more income than from bank CD. Young gets better borrowing rate and terms. By cutting out the middlemen, it is a win for both parties.

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Re: On Leverage

Post by EfficientInvestor » Fri Mar 08, 2019 8:43 am

grayfox wrote:
Fri Mar 08, 2019 7:04 am
I have come full circle and I am back to my original thought that the most important thing is the terms of the loan. Margin accounts are so one-sided they could be a comedy joke. Mortgage would work (ok, it's actually leveraging the house), but the rate is high.

The best idea I've heard so far is to borrow from a family member. But I would pay it off like a mortage. Here's the idea.

A 60-year-old retired family member has assets and needs income. A 20-year-old family member wants to invest in stocks, but has no money. However he graduated from high school and has a steady job. Old could put $10,000 in a 3.0% 5-year CD. Instead lends to Young at 3.4% for 10 years. From mortgage calculator, that would be $98.42 per month income for Old. That is higher than what a 10-year annuity would pay which is $93.10.

Young invests in 50/50 VYM/VYMI which yields $150 + $197.50 = $347.50 per year, or $28.95 per month. He would have to make up the difference, $69.46 per month from his paycheck.

:arrow: Old gets more income than from bank CD. Young gets better borrowing rate and terms. By cutting out the middlemen, it is a win for both parties.
If I were that 20 year old, I would take that $10k, open up a margin account with Interactive Broker (IB), and create a 2X 40/60 portfolio using margin. The backtests below reflects this portfolio and accounts for the 1.5% you would have to pay to IB on top of the fed fund/libor rate, which is represented by the negative cash position.
https://www.portfoliovisualizer.com/bac ... on3_1=-100

Here is a backtest of a 60/40 fund and all stock fund over the same time period:
https://www.portfoliovisualizer.com/bac ... tion2_1=40

Here are overall results of both backtests:

Jan 1987 - Feb 2019
2X 40/60 - CAGR = 12.5%, Max DD = -32.0%
60/40 - CAGR = 9.6%, Max DD = -27.0%
S&P 500 - CAGR = 10.2%, Max DD = -51.0%

Bottom line...regardless of where you get your capital, these results show that a more efficient portfolio with leverage applied has produced better risk-adjusted returns than either a 60/40 portfolio or the S&P 500. This time period includes many instances where there wasn't much spread between the borrow rate and the long term bond rate.

Another comparable option would be to use 2X leveraged ETFs/mutual funds. Below is a backtest of a 2X 40/60 portfolio using leveraged products vs VYM. The 2X 40/60 uses 7-10 year treasuries for the bond portion. VYMI has only been around since 2017, so I didn't include it in the backtest.

https://www.portfoliovisualizer.com/bac ... ion3_2=100

Jan 2007 - Feb 2019
2X 40/60 - CAGR = 11.1%, Max DD = -21.7%
VYM - CAGR = 7.5%, Max DD = -51.8%
S&P 500 - CAGR = 7.8%, Max DD = -51.0%

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Re: On Leverage

Post by grayfox » Sat Mar 09, 2019 6:31 am

EfficientInvestor wrote:
Fri Mar 08, 2019 8:43 am

If I were that 20 year old, I would take that $10k, open up a margin account with Interactive Broker (IB), and create a 2X 40/60 portfolio using margin. The backtests below reflects this portfolio and accounts for the 1.5% you would have to pay to IB on top of the fed fund/libor rate, which is represented by the negative cash position.
https://www.portfoliovisualizer.com/bac ... on3_1=-100

Here is a backtest of a 60/40 fund and all stock fund over the same time period:
https://www.portfoliovisualizer.com/bac ... tion2_1=40

Here are overall results of both backtests:

Jan 1987 - Feb 2019
2X 40/60 - CAGR = 12.5%, Max DD = -32.0%
60/40 - CAGR = 9.6%, Max DD = -27.0%
S&P 500 - CAGR = 10.2%, Max DD = -51.0%

Bottom line...regardless of where you get your capital, these results show that a more efficient portfolio with leverage applied has produced better risk-adjusted returns than either a 60/40 portfolio or the S&P 500. This time period includes many instances where there wasn't much spread between the borrow rate and the long term bond rate.

Another comparable option would be to use 2X leveraged ETFs/mutual funds. Below is a backtest of a 2X 40/60 portfolio using leveraged products vs VYM. The 2X 40/60 uses 7-10 year treasuries for the bond portion. VYMI has only been around since 2017, so I didn't include it in the backtest.

https://www.portfoliovisualizer.com/bac ... ion3_2=100

Jan 2007 - Feb 2019
2X 40/60 - CAGR = 11.1%, Max DD = -21.7%
VYM - CAGR = 7.5%, Max DD = -51.8%
S&P 500 - CAGR = 7.8%, Max DD = -51.0%
Very interesting! This would have worked out quite well.

Maybe the older generations should consider lending money to their offspring so they can start investing in stocks at an early age. Stocks are best as a long-term investment. The young have a longer horizon than the old. Hand them $10,000 and that leverage book to read. Why not?

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Re: On Leverage

Post by grayfox » Sun Mar 10, 2019 7:52 am

OK, due to developments elsewhere, I am going to look at two key dates: January 1955 and January 1982.

Code: Select all

                        Jan-1955        Jan-1982
                
FFR                     1.39%           13.22%
1M LIBOR + 1%           2.39%           14.22%          
30-YR FIXED MORTGAGE                    17.40%
20-YR TREAS             2.75%           14.57%          
CPI-U Year Ago          26.940          87.200
CPI-U                   26.770          94.400
CPI CHANGE Y-O-Y        -0.63%          8.26%
INFLATION EXP           -0.63%          8.26% 
CAPE                    18.29           7.39
1/CAPE                  5.47%           13.53%  
VFINX E.R.              4.84%           21.79%
VUSTX E.R.              2.75%           14.57%
40/60 VFINX/VUSTX       3.58%           17.46%
SPREAD (bsp)            119.46          323.75
Jan-1955: very low short term interest rates 1.39, low long-term rates 2.75 (about the same as today). Yield-curve not very steep. Slightly above average stock valuations, 18.29. Back then, they probably thought that was high! Year-over-year consumer price change was negative -0.63%.

Borrowing rates were excellent for leveraging. But the prospects for stocks and bonds were mediocre, at best. The profit for 40/60 was only +119 bsp. I would have rejected the leveraged 40/60 trade in 1955.

Jan-1982: extreme high interest rates 14%, but yield curve was not very steep. High inflation was just experienced 8% and consumers expected inflation to remain high. The huge thing is stock valuations were near the bottom, CAPE=7.39.

Borrowing rates were horrendous for leveraging, 14%. I recall getting 13% in Fidelity Cash Reserves. LT Treasury rates were high 14%, but much of that was built-in inflation expectations. People were still expecting double-digit inflation. Who knew that inflation would be brought way down? Nobody! The profit on the 40/60 leveraged trade was +323 bsp. Not too bad, but below my minimum profit requirement I would have rejected the leveraged 40/60 trade in 1982.

:idea: But leveraging stocks in 1982 was another story. Some of the lowest valuations in history. Expected real return was around 13.5% ! I would consider leveraging stocks in 1982, if I had good borrowing terms. As a minimum, I would recommend going 100% S&P500 to anyone investing in 1982.

Sources:
https://fred.stlouisfed.org/series/fedfunds
https://fred.stlouisfed.org/series/MORTG
https://fred.stlouisfed.org/series/GS20
https://fred.stlouisfed.org/series/CPIAUCSL
http://www.multpl.com/shiller-pe/table?f=m

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Re: On Leverage

Post by grayfox » Sun Mar 10, 2019 11:52 am

Another point I would make about 1955-1981 is that no one in 1955 would have predicted how poor this 3x 40/60 leverage strategy would have worked out. In 1955, nobody would have expected the high inflation and interest rates at 14%.

Image

Same with 1982-2019. Nobody in 1982 would have predicted that inflation would be tamed and bond yield would be back to 2.8%

The results depend on what happens 20 years later. The current conditions are important, but they only tell you where you are starting from.

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Re: On Leverage

Post by grayfox » Mon Mar 11, 2019 7:21 am

One conclusion I am drawing on this leverage business is that there are times when it makes sense to lever up and times when it does not. With BH-style portfolio you can just set it and forget it. Just pick your asset and keep adding to it. You don't ever have to look at it or make a decision. Even when it's 100% stock.

With leverage, you have to constantly watch it. There will be times when you should de-leverage and times when you should add leverage. Not Buy-and-Hold. This definitely requires active management, like market timing.

Another thing I am noticing is that, since the hammer came down on the 3x 40/60, people won't let go of it. I guess that's human nature. So the data mining by backtest begins. making adjustments to the mix. Add some of this, a little of that, re-run the backtest, until it works optimally. I think it's called Overfitting.

And then there are the explanations about why the past disaster will not repeat. Future failures will probably be new disasters never before seen. There can not be huge potential reward without huge risk.

Rule 62 Corollary. The greater the profit, the riskier the road.

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Re: On Leverage

Post by HEDGEFUNDIE » Mon Mar 11, 2019 9:03 am

grayfox wrote:
Mon Mar 11, 2019 7:21 am
Another thing I am noticing is that, since the hammer came down on the 3x 40/60, people won't let go of it. I guess that's human nature. So the data mining by backtest begins. making adjustments to the mix. Add some of this, a little of that, re-run the backtest, until it works optimally. I think it's called Overfitting.
Others may be overfitting but I am not. I have been consistent with the strategy through the entire thousand+ posts. Two fund portfolio at 40/60, rebalanced quarterly. Rinse and repeat for 20-30 years.
And then there are the explanations about why the past disaster will not repeat. Future failures will probably be new disasters never before seen. There can not be huge potential reward without huge risk.
I have been transparent about the “past disaster” and have clearly stated that, if you think it will repeat, you should not pursue the strategy. No attempt to overfit as others are trying to do.

I do agree with you on the future “unknown unknowns” though, but that’s a risk we always take by being in the markets.

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Re: On Leverage

Post by grayfox » Tue Mar 12, 2019 7:28 am

I like to apply the Scientific Method to these problems. Make a few observations and come up with a simple hypothesis to explain what's going on. Then look for evidence that can prove the hypothesis wrong. Watch The Scientific Method-Richard Feynman.

Hypothesis: Start with a low risk bond-heavy 40/60 portfolio with high Sharpe Ratio. Lever it up 3x until it has the same risk as 100% stock but much higher return.
This is supported by the MPT so it sounds promising.
Look for evidence to refute it. That evidence would be backtesting.

Go back to 2010. Works fine.
Go back to 1987. Works fine.
Go back to 1982. Works fine.
Go back to 1955. -97% drawdown. Much higher risk than 100% stock, and the same return 1955-2019.
That's the damning evidence. As Feyman says, "it's wrong."
You have to reject the hypothesis.

When it comes out wrong, now what?

One reaction is thing is to throw out the damning data point. That can't happen again, so that data is irrelevant. The hypothesis still holds.

Another common reaction is to want to salvage the idea. So add more rules on top of the simple hypothesis. Before you know it, its not a simple hypothesis. E.g. geocentric model with all the epicycles. Sometimes you have to replace the old idea with a new idea.

:idea: My hypothesis is that you can't have a strategy that offers a spectacular reward without a chance for spectacular failure. The world won't allow that. If it was possible, everyone would do it, get rich and then who would do all the work? The economy and markets are there to confound any efforts to beat it.

This is just more evidence supporting Rule 62. The greater the reward, the riskier the road.
Last edited by grayfox on Tue Mar 12, 2019 8:32 am, edited 2 times in total.

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Re: On Leverage

Post by acegolfer » Tue Mar 12, 2019 7:35 am

grayfox wrote:
Tue Mar 12, 2019 7:28 am
My hypothesis is that you can't have a strategy that offers a spectacular reward without a chance for spectacular failure. The world won't allow that. If it was possible, everyone would do it, get rich and then who would do all the work? The economy and markets are there to confound any efforts to beat it.
sounds like efficient market hypothesis to me.

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Re: On Leverage

Post by HEDGEFUNDIE » Tue Mar 12, 2019 8:37 am

grayfox wrote:
Tue Mar 12, 2019 7:28 am
I like to apply the Scientific Method to these problems. Make a few observations and come up with a simple hypothesis to explain what's going on. Then look for evidence that can prove the hypothesis wrong. Watch The Scientific Method-Richard Feynman.

Hypothesis: Start with a low risk bond-heavy 40/60 portfolio with high Sharpe Ratio. Lever it up 3x until it has the same risk as 100% stock but much higher return.
This is supported by the MPT so it sounds promising.
Look for evidence to refute it. That evidence would be backtesting.

Go back to 2010. Works fine.
Go back to 1987. Works fine.
Go back to 1982. Works fine.
Go back to 1955. -97% drawdown. Much higher risk than 100% stock, and the same return 1955-2019.
That's the damning evidence. As Feyman says, "it's wrong."
You have to reject the hypothesis.

When it comes out wrong, now what? It's not uncommon to want to salvage the idea, so add more rules on top of the simple hypothesis. Before you know it, its not a simple hypothesis. E.g. geocentric model with all the epicycles. Sometimes you have to replace the old idea with a new idea.

:idea: My hypothesis is that you can't have a strategy that offers a spectacular reward without a chance for spectacular failure. The world won't allow that. If it was possible, everyone would do it, get rich and then who would do all the work? The economy and markets are there to confound any efforts to beat it.

This is just more evidence supporting Rule 62. The greater the reward, the riskier the road.
Damning evidence that the hypothesis is wrong?

I and others have provided evidence that the world changed rather dramatically in 1982.

You seem to be philosophically inclined, so let me make an analogy to Kuhn. Pre-1982, everyone was operating under certain assumptions about how the Fed behaves, “normal” science, if you will. All of a sudden those assumptions were upended, a revolution ensued, and now we are living in an entirely new paradigm.
Last edited by HEDGEFUNDIE on Tue Mar 12, 2019 9:40 am, edited 1 time in total.

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Re: On Leverage

Post by grayfox » Tue Mar 12, 2019 9:07 am

The were financial panics in the late 19th century and early 20th century. See Panic of 1873. Panic of 1907.

So they formed the Federal Reserve Bank in 1913. No more panics, they fixed that.
But then the Great Depression came along.

So they came up with Keynesian Economics, deficit spending, etc. and fixed that.
But then the Great Inflation came along. Stagflation. High inflation, slow growth and high unemployment. It was supposed to be impossible.

So Paul Volker raised interest rates, broke the back of inflation and fixed that. No more high inflation.
But the financial crisis and Great Recession comes along.

So they printed a bunch of money, made helicopter drops and bailed out all the banks.

They keep fixing stuff, but then the system breaks in a new way. There is always a new panic, crisis, depression, whatever coming along. There will be surprises, things that are thought to be impossible, until they happen.

If there is a chance of high return, there has to be a lot of risk. Maybe the risk hasn't shown up yet, so you think it is not there. But it is there, lurking. The market is like the mischievous trickster Puck, always there to confound your plans.

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Re: On Leverage

Post by HEDGEFUNDIE » Tue Mar 12, 2019 9:46 am

I have never said “the risk is not there.” There is a reason I’m keeping this strategy to 15% of my portfolio.

What I have said, adamantly so, is that we are never returning to the pre-1982 days of high rising inflation. We saw proof of this in 2009. If helicopter Ben could not drive up inflation with next-to-free-money, what could?

Again, I agree with you that the next crisis will look different from the past. But then how can one pre-judge how any strategy would behave? It might well be the case that the three fund portfolio crashes and burns while my strategy rides off clear into the sunset.

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Re: On Leverage

Post by DonIce » Tue Mar 12, 2019 11:38 am

HEDGEFUNDIE wrote:
Tue Mar 12, 2019 9:46 am
What I have said, adamantly so, is that we are never returning to the pre-1982 days of high rising inflation. We saw proof of this in 2009. If helicopter Ben could not drive up inflation with next-to-free-money, what could?
What could cause high inflation? The rise of new assets that are considered safer than US federal government debt. This could come for a variety of reasons, including increasing US federal deficits which could erode confidence in the safety of US debt, or the rise of other countries to a competitive or pre-eminent economic position relative to the US, or any other unforeseen event. If US government debt was no longer the "flight to safety" asset, then the 2009 fed performance could perhaps not be repeated without causing significant inflation.

My opinion is that any time a lot of people say that something "could never happen again" is good indicator of it happening again soon. When people think something can't happen, they stop guarding against it, thereby inviting it to happen.

That's not to say a leveraged portfolio strategy can't work, or that now is a worse time to implement such a strategy than any other time. Obviously we can't know that for sure either way. In fact, after I accumulate a bit more capital I'll likely pursue a moderately leveraged strategy of some sort as well. But it should be gone into without rationalizing that risks that existed in the past are now magically gone due to "paradigm shifts".

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Re: On Leverage

Post by HEDGEFUNDIE » Tue Mar 12, 2019 11:48 am

DonIce wrote:
Tue Mar 12, 2019 11:38 am
HEDGEFUNDIE wrote:
Tue Mar 12, 2019 9:46 am
What I have said, adamantly so, is that we are never returning to the pre-1982 days of high rising inflation. We saw proof of this in 2009. If helicopter Ben could not drive up inflation with next-to-free-money, what could?
What could cause high inflation? The rise of new assets that are considered safer than US federal government debt. This could come for a variety of reasons, including increasing US federal deficits which could erode confidence in the safety of US debt, or the rise of other countries to a competitive or pre-eminent economic position relative to the US, or any other unforeseen event. If US government debt was no longer the "flight to safety" asset, then the 2009 fed performance could perhaps not be repeated without causing significant inflation.
Agree 100%

If and when the US Dollar /debt loses its status as the world's reserve asset, I'll be the first change my strategy to 60% 3X Renminbi, Euro, Yen, Martian Dollars, whatever it turns out to be!

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Re: On Leverage

Post by grayfox » Wed Mar 13, 2019 6:58 am

That could be a thread by itself to debate whether high inflation is off the table because of a paradigm shift in monetary policy. This would interest a lot of Bogleheads considering that its commonly recommended that half of bonds should be inflation-indexed bonds. I'm sure grok would be glad to hear that he can sell all his TIPS.

Meanwhile, I see that there is a third leverage strategy. Just to review:

First is leverage up low volatility portfolio like 40/60 until it has similar risk as 100% stocks. E.g. 2x or 3x 40/60 with Leveraged ETFs. Possibility to double the return of S&P500. But this maintains the same high-risk portfolio forever, so when/if the risk shows up you are guaranteed to experience deep drawdowns.

Second is the Ayres & Nalebuff Lifecycle investing which sounds like age-in-bonds on steroids. Start with something like 200/0/-100 and end up with 40/60/0. This has the benefit that it gets less risky over time. If you are lucky, you will be de-levereged when the risk does show up.

The third I'm seeing is Zvi Bodie's 90% TIPS / 10% LEAPS discussed here. Apparently LEAPS are call options on S&P500. I think they are for 3-years. Somehow, a call option acts like leverage. This sounds like the least risky approach to using leverage.** How would you backtest that with portviz?

** Maybe not. It sounds like you can loose 10% every time your call options expire worthless. Death by 1,000 cuts.

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Re: On Leverage

Post by pezblanco » Wed Mar 13, 2019 8:02 pm

grayfox wrote:
Wed Mar 13, 2019 6:58 am
That could be a thread by itself to debate whether high inflation is off the table because of a paradigm shift in monetary policy. This would interest a lot of Bogleheads considering that its commonly recommended that half of bonds should be inflation-indexed bonds. I'm sure grok would be glad to hear that he can sell all his TIPS.

Meanwhile, I see that there is a third leverage strategy. Just to review:

First is leverage up low volatility portfolio like 40/60 until it has similar risk as 100% stocks. E.g. 2x or 3x 40/60 with Leveraged ETFs. Possibility to double the return of S&P500. But this maintains the same high-risk portfolio forever, so when/if the risk shows up you are guaranteed to experience deep drawdowns.

Second is the Ayres & Nalebuff Lifecycle investing which sounds like age-in-bonds on steroids. Start with something like 200/0/-100 and end up with 40/60/0. This has the benefit that it gets less risky over time. If you are lucky, you will be de-levereged when the risk does show up.

The third I'm seeing is Zvi Bodie's 90% TIPS / 10% LEAPS discussed here. Apparently LEAPS are call options on S&P500. I think they are for 3-years. Somehow, a call option acts like leverage. This sounds like the least risky approach to using leverage.** How would you backtest that with portviz?

** Maybe not. It sounds like you can loose 10% every time your call options expire worthless. Death by 1,000 cuts.
The most basic strategy is just to leverage up stocks right? ... LEAPS are just long options on any index, not just the S&P500. I've been doing some calculations and basically you can borrow money using LEAPS for around 3.5% nominal right now. It is a little tricky to compute the borrowing rate since the dividends being paid in the future aren't known exactly (or guaranteed). So if inflation is 2.5% then you can borrow at 1% real. The S&P should give you at least 5% real (long term it has given 7% real) going forward from our high valuations. So, that gives you your 4% real cushion. Shouldn't you be pulling the trigger on this, Grayfox? :D

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