Author Topic: Pay off mortgage or invest (revisited)  (Read 9881 times)

tooqk4u22

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Pay off mortgage or invest (revisited)
« on: June 14, 2012, 03:44:34 PM »
http://www.mrmoneymustache.com/forum/real-estate-and-landlording/rent-vs-owning-with/

The above thread got me thinking and I thinkg the analysis plays directly into the pay off your mortgage or invest question.  I have  a mortgage with a 3.50% rate (reality is I could probably refi and bring down my rate further) and if invest in VGSLX and get 3.25% its almost a wash but I have signifcant diversification so no single market (such as my single home market) take me down.

Not only does this suggest to not pay off the mortgage but it also suggests that I should refi and get as max a loan as possible and invest in VGSLX - again my exposure to real estate would be the same but I would have the diversification. 

What do you think?

thomasa510

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Re: Pay off mortgage or invest (revisited)
« Reply #1 on: June 14, 2012, 04:24:53 PM »
It depends on what the amount of your mortgage outstanding is (in terms of refinancing or not). 

The yield on the REIT index is only part of the story, as there can be significiant appreciation/depreciation as well (which won't necessarily mirror your local market).  It provides you the option to invest beyond your local market but there are also tax considerations (I know most REITs are taxed at your ordinary income but I'm not sure about this fund) and mortgage interest deductions to consider.

It appears as if VGSLX holds other REITs other than residential property, so you willl be diversifying into commercial, industrial, and possibly healthcare REITs.

Luckily, you don't have to make an all or nothing decision and can allocate your funds in part to each of these options.

Also, it may be easier to just invest in VNQ instead (disclaimer - which I personally own), which is the same investment but in an easier to trade ETF form.

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #2 on: June 14, 2012, 07:47:43 PM »
I like the strategy.

On top of diversification, you get the potential upside of the stock (on top of dividends) while not giving up any of the upside of potential house appreciation.

And a 3.5% rate, after mortgage interest deduction is practically free (or negative, they pay you to take the money) after inflation.

Some hate risk, others hate debt.  If you fall into one of these two categories, don't consider it.

If you can handle some risk for some upside, I think it's not a bad idea.
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Enphuego

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Re: Pay off mortgage or invest (revisited)
« Reply #3 on: June 18, 2012, 04:05:36 PM »

velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #4 on: June 18, 2012, 08:21:38 PM »
there are also tax considerations

REITs are tax-inefficient, and as a rule of thumb, they should be placed into tax-deferred or tax-free accounts.

This article has the best analysis I've seen on the subject:

http://www.kitces.com/blog/archives/198-Why-Is-It-Risky-To-Buy-Stocks-On-Margin-But-Prudent-To-Buy-Them-On-Mortgage.html

Interesting. All three cases that the author considers involve some kind of investing on margin. I'm pretty sure that 2:1 margin wins over no margin for the long-term investor. I'm comfortable with not paying off the mortgage, but I'm not sure that I would be comfortable paying off the house and investing in a 2x beta portfolio. Are they really equivalent? Aren't there practical reasons why plenty of people recommend the former, and no one recommends the latter?

smedleyb

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Re: Pay off mortgage or invest (revisited)
« Reply #5 on: June 19, 2012, 06:31:32 AM »
This article has the best analysis I've seen on the subject:

http://www.kitces.com/blog/archives/198-Why-Is-It-Risky-To-Buy-Stocks-On-Margin-But-Prudent-To-Buy-Them-On-Mortgage.html

Enphuego, thanks for the link.  Great analysis of the use of debt to increase market returns vs. just dialing up the beta on a portfolio to achieve similar returns -- with less risk overall.  Timely article for me, too, as I was debating tapping equity for investment purposes but now see the gap in my logic.  I think I'll stay the course and seek to retire the mortgage sooner rather than later. 

velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #6 on: June 19, 2012, 02:28:28 PM »
Aren't there practical reasons why plenty of people recommend the former, and no one recommends the latter?

I've thought of one. If you invest in a 401k, then your fund choices are limited. You probably couldn't hold a 2x S&P500, etc. If half of your holdings are in the 401k, then to make up the slack, your non-401k investments would have to have 3x beta. Then you would be more likely to run into problems normally associated with leveraged investments.

For taxable investment accounts, there could still be decay issues for certain leveraged ETFs, but overall, it seems to make sense.

AJ

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Re: Pay off mortgage or invest (revisited)
« Reply #7 on: June 19, 2012, 03:17:23 PM »
Aren't there practical reasons why plenty of people recommend the former, and no one recommends the latter?

I've thought of one. If you invest in a 401k, then your fund choices are limited. You probably couldn't hold a 2x S&P500, etc. If half of your holdings are in the 401k, then to make up the slack, your non-401k investments would have to have 3x beta. Then you would be more likely to run into problems normally associated with leveraged investments.

For taxable investment accounts, there could still be decay issues for certain leveraged ETFs, but overall, it seems to make sense.

That's true, but you don't really have a choice if your funds are in a 401k -- I mean, you can't just take them out and pay off your mortgage, even if it was financially advantageous.

The only practical reason I can think of is the one you allude to: that people are just more familiar with mortgage loans than with 2x ETFs or options (or even margin), and are therefore more comfortable with the strategy. If the results are equal, there's no reason for a CFP to try and convince their clients to choose the more confusing strategy over a more familiar one.

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #8 on: June 19, 2012, 06:51:02 PM »
Often decay on leveraged ETFs make them unfeasible for anything but short term trading, a no-no for many investors.

Dialing up the beta assumes that risk/reward are perfectly correlated.  This is not the case.
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smedleyb

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Re: Pay off mortgage or invest (revisited)
« Reply #9 on: June 19, 2012, 06:58:56 PM »
Often decay on leveraged ETFs make them unfeasible for anything but short term trading, a no-no for many investors.

Dialing up the beta assumes that risk/reward are perfectly correlated.  This is not the case.

I want to invest in a 2x short 2x/3x long/short ETFs. 

velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #10 on: June 19, 2012, 07:14:46 PM »
I want to invest in a 2x short 2x/3x long/short ETFs.

Come again?

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #11 on: June 19, 2012, 07:18:20 PM »
Often decay on leveraged ETFs make them unfeasible for anything but short term trading, a no-no for many investors.

Dialing up the beta assumes that risk/reward are perfectly correlated.  This is not the case.

I want to invest in a 2x short 2x/3x long/short ETFs.

Again, decay will * you unless you're day trading them.  Holding them guarantees you will lose money (even if you hold a long, and the market goes up) due to short term volatility.
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smedleyb

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Re: Pay off mortgage or invest (revisited)
« Reply #12 on: June 19, 2012, 08:54:42 PM »
I want to invest in a 2x short 2x/3x long/short ETFs.

Come again?

I want to short every leveraged ETF in existence, precisely because of the decay, 2 times over. 

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #13 on: June 19, 2012, 09:15:41 PM »
I want to invest in a 2x short 2x/3x long/short ETFs.

Come again?

I want to short every leveraged ETF in existence, precisely because of the decay, 2 times over.

Ah, shorting them.  Yes, that would be a nice guaranteed return, if it was possible.
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velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #14 on: June 20, 2012, 06:20:24 AM »
I want to short every leveraged ETF in existence, precisely because of the decay, 2 times over.

Ah, shorting them.  Yes, that would be a nice guaranteed return, if it was possible.
[/quote]

What makes it impossible?

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #15 on: June 20, 2012, 02:37:54 PM »
The biggest issue is getting the shares to short.

There's also the risk of a really strong bear or bull market wiping you out.

The idea is fun in theory, less good in practice.
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smedleyb

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Re: Pay off mortgage or invest (revisited)
« Reply #16 on: June 21, 2012, 05:42:38 AM »
The biggest issue is getting the shares to short.

There's also the risk of a really strong bear or bull market wiping you out.

The idea is fun in theory, less good in practice.

First off, create a dollar neutral portfolio of an inverse long and short leveraged ETF:

S&P 500 2X long:  SSO, $54.16
S&P 500 2X short: SDS $15.83

Short 500 shares of SSO, short 1700 shares of SDS.  Regardless of which direction the market moves, you're covered. 

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #17 on: June 21, 2012, 04:01:55 PM »
O RLY?

What if the market moves in one direction such that either of those gain over 100%?

You lose money.

For example, let's say a huge market jump causes one to gain 200%.  When shorting, you can't gain over 100% (because it cannot fall below 0), but you can lose over 100% (because it can theoretically grow to infinity).

As, I said:
Quote
There's also the risk of a really strong bear or bull market wiping you out.
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Bank

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Re: Pay off mortgage or invest (revisited)
« Reply #18 on: June 21, 2012, 04:29:36 PM »
Not my area of finance, so I'm just here to learn.  The article below would appear to support Arebelspy.  Response?

http://news.morningstar.com/articlenet/article.aspx?id=271892

Edit:  In case my question is unclear, it appears to show that you are only guaranteed that the hedge/offset works for a short period.  Is this wrong?
« Last Edit: June 21, 2012, 04:32:03 PM by Bank(rupt$y) »

velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #19 on: June 22, 2012, 12:23:14 PM »
Not my area of finance, so I'm just here to learn.  The article below would appear to support Arebelspy.  Response?

http://news.morningstar.com/articlenet/article.aspx?id=271892

Edit:  In case my question is unclear, it appears to show that you are only guaranteed that the hedge/offset works for a short period.  Is this wrong?

Interesting.

I looked at a Proshares 2x long S&P500 prospectus, and indeed it says that returns beyond one day will differ from 2x S&P500. The article you linked says that the way it differs will result in a decay.

But I think this is the effect that smedleyb wants. If you can short an ETF that's guaranteed to go down because of the decay described in the Morningstar article, then you win. So far, we've thought of two risks: (1) what if the market swing is so dramatic that it wipes out one of the funds and then some, and (2) what if you can't find shares to keep it going? I'm guessing there are other risks that are harder to pinpoint.

(The rest of this post is about trying to figure out the leveraged ETF decay effect.)

I'm still trying to wrap my brain around the decay effect. I found an NYU paper that goes more in depth:
Path-dependence of Leveraged ETF returns (pdf)

"[R]eturns of the LETFs have predominantly underperformed the static leveraged strategy. This is particularly the case in periods when returns are moderate and volatility is high. LETFs outperform the static leveraged strategy only when returns are large and volatility is small."

In the LETF case, you buy shares of the LETF. In the static leveraged strategy, you borrow to buy shares, then sell shares and pay back the loan.

I figured looking at a 2-day time period might help. Ignoring fees, suppose the market has return r1 on one day and r2 on the next day so that the total 2-day return is (1+r1)*(1+r2)=(1+rTOT). For a particular total return, you can solve for r2 in terms of r1.

r2=(1+rTOT)/(1+r1)-1

The 2x LETF return will be (1+2*r1)*(1+2*r2)-1, while the static leveraged return would be 2*(1+rTOT)-2. If you difference those two, you can find out what you stand to gain or lose by buying the LETF rather than buying on margin, just due to volatility. Making r1 the dependent variable, and plotting the gain/loss for several rTOT (shown in the legend) gives you this:


The peaks occur where r1=r2, that is, if volatility is low. You do better with the LETF only when both day's returns are the same sign as the total return, and the loss from different signs is greater than the gain when they are the same.  Those two things together could account for the significance of the decay noted in the Morningstar article. Also, The LETF advantage is only significant for large total returns. This seems to match the above statement from the NYU paper.

velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #20 on: June 22, 2012, 12:43:40 PM »
Bringing it back to the mortgage vs. invest question, I'll side with Rebel Spy when he said:

Dialing up the beta assumes that risk/reward are perfectly correlated.  This is not the case.

and conclude that leveraging with a mortgage is the best of the three options that Michael Kitces presented, though it is pretty close to investing on margin. Kitces says in one of the comments,

Quote
yes, it's true that margin loans are callable and mortgages typically are not, and that margin loans are typically variable while mortgages are fixed.

Nonetheless, when was the last time you heard anyone say to a client "Hey, I've got a great idea - why don't you leverage up your portfolio 2:1 to juice your returns... and we'll choose to do it with a loan against your house because it's a fixed rate and not callable." I've NEVER heard that.

Maybe an adviser wouldn't say it like that, but plenty of people would say to invest rather than paying down the mortgage, and they might stay away from margin investing because of variable rates and margin calls. I'm confident that it's better to invest rather than pay down my mortgage. Since I believe that it's a better strategy than using margin or higher beta, I will even recommend it to other people. Anyone else agree or disagree?

I also wonder if he's missing something important. If you consider the timing of a mortgage (regular payments) vs. the typical timing of a margin loan (1 time?), you might find an effect from correlations in market returns. I've never bought on margin, so I don't know how it works.

Not only does this suggest to not pay off the mortgage but it also suggests that I should refi and get as max a loan as possible and invest in VGSLX - again my exposure to real estate would be the same but I would have the diversification. 

What do you think?

I think a typical investor wouldn't want such a large exposure to real estate, unless you know for sure that the particular real estate is cheap, and that's a very regional thing, not necessarily something you would get through a Vanguard fund. Instead, choose asset allocations up front, and use your home equity as part or all of the real estate allocation.

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #21 on: June 22, 2012, 03:58:16 PM »
You're overcomplicating the decay.  It's simpler than that.  Because going down in percent requires higher gains to make back up, you lose over time due to volatility.

Let's say you have a 3x fund tied to the s&p500.

You put $100 in it.

Lets say the s&p is up 5% one day.  Your fund is up 15%.  S&P is at 105.  You have 115.

Let's say it's down 4% the next day.  S&P is at 100.8.  You are down 12% and at 101.2.  Notice this is not 3X the gain (it's less than 2X).

Let's say the next day it's down 5% (you 15%).  S&P is at 95.76.  You are at 86.02.  Next day it goes up 4.4%.  S&P is at 99.97, essentially flat.  You are at 89.8.

You have lost 10% of your monies even though the S&P was flat!

Essentially because when you lose 10%, it now takes a gain of 11% to get back there.  If the market only goes one way, fine.  But due to volatility and it fluxuating back and forth, when you lose one day, win the next, etc. etc. the fund decays and loses value.

Now that we have the decay understood, let's look at why shorting them doesn't work (besides the MAJOR problem of availability of shares to short).

You're opening yourself a huge risk due to the potential of a runaway market.  When shorting something, you cannot earn more than 100% on your money (because the worth of the item cannot fall below 0, where you gain 100%).  But you can owe more than 100% (if it doubles in value when you're shorting it), all the way up to infinity.

Let's say each are at $50, and you're shorting hoping to take advantage of the decay.   Say one gains more than 33.% (which at 3x leverage is 100% gain), the other loses that much.  But if it gains more than that, your gains are capped but your losses are not.

It's like certain option trading strategies, scraping small profits 95% of the time, but then the 5% you owe, it wipes out all the gains.
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velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #22 on: June 22, 2012, 05:26:18 PM »
You're overcomplicating the decay.  It's simpler than that.  Because going down in percent requires higher gains to make back up, you lose over time due to volatility.

I wouldn't say I overcomplicated it. Did you look at the NYU paper?

In some cases, you come out ahead of static leverage with a leveraged ETF, and single examples won't tell you which trend will win out. My little two-day run won't tell you, either, but it does give a little more insight. The linked paper tells you that the negative trend wins out.

You're opening yourself a huge risk due to the potential of a runaway market.  When shorting something, you cannot earn more than 100% on your money (because the worth of the item cannot fall below 0, where you gain 100%).  But you can owe more than 100% (if it doubles in value when you're shorting it), all the way up to infinity.

But an extreme day for the S&P500 would be what, +/-15%? Of the two factors, it sounds like share availability is the bigger risk, though I have no experience or insight into that phenomenon. Still, I keep thinking that there's something else we're missing that would make this totally intractable.

On a related note, in the Kitces link, he says

Quote
The point is simply that in portfolio C, I can easily replicate a portfolio that is, BY DEFINITION "The return of portfolios A and B, multiplied by 2" - WHATEVER diversified or other portfolio you want to make A and B in the first place. Maybe it's stocks. Maybe it's a balanced portfolio. Maybe I recreate it with leveraged funds. Maybe I recreate it with options. The point remains, ANY portfolio you create in scenario A and B, I can create in scenario C without debt, by owning more volatile stuff or synthetically creating more volatile stuff with options. Which again, lets me get the same returns, WITHOUT debt leverage.

Can we conclude that this is an oversimplification?

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #23 on: June 22, 2012, 07:37:59 PM »
You're overcomplicating the decay.  It's simpler than that.  Because going down in percent requires higher gains to make back up, you lose over time due to volatility.

I wouldn't say I overcomplicated it. Did you look at the NYU paper?

In some cases, you come out ahead of static leverage with a leveraged ETF, and single examples won't tell you which trend will win out. My little two-day run won't tell you, either, but it does give a little more insight. The linked paper tells you that the negative trend wins out.

Yes, and it completely confirms what I said.

I noted that due to volitility, you have decay, and it only works if the market moves strongly in one direction.  This is almost exactly what they say:
Quote
This is particularly the case in periods when returns are moderate and volatility is high. LETFs outperform the static leveraged strategy only when returns are large and volatility is small.

The negative trend wins out due to volitility seen in our markets, something even more prevelant today than ever (a large part of which is due to HFT).

This Motley Fool article explains the decay nicely, and even goes into 4 reasons why people shorting them to take advantage of the decay got into trouble...

http://caps.fool.com/Blogs/understanding-etf-decay-part/597928

But an extreme day for the S&P500 would be what, +/-15%? Of the two factors, it sounds like share availability is the bigger risk, though I have no experience or insight into that phenomenon. Still, I keep thinking that there's something else we're missing that would make this totally intractable.

You're underestimating the risk of your upside being capped with no downside cap.  After a few days, the two you are shorting can be grossely out of whack, and the one can gain much more than the other can lose.  Since you're betting on them to lose, you're in trouble.  It's very likely that this will happen at some point.

This article about shorting FAS/FAZ helps explain it:
http://seekingalpha.com/article/245610-financial-etfs-shorting-fas-faz-at-the-same-time

In particular, the relevant part to what I was talking about (about how your upside is capped, but downside is infinite):
Quote
Let's take current 2011 prices on the FAZ and FAS. The FAS is around $30 per share and the FAZ is around $9. If we short the FAS and FAZ at the same time, theory says that if the FAS goes up by 10%, the FAZ will drop by 10% and vice-versa. So, let's say the market takes off and the FAS jumps 10% each day over the next 3 days. Remember, it is 3x leveraged so this could easily happen in a breakout market. We should be equally protected because each moves 10% each day in opposite direction? This is where the novice trader needs to listen up.

If the FAS jumps 10% each day for 3 days, it will be trading near $40 per share or up about $10 per share. If the FAZ drops 10% each day for 3 days, it will be trading near $6.50 per share. Ouch! If you had shorted both stocks, you would have one stock with a loss of $10 per share and one with a gain of just $2.50. Here is the real problem: The FAS could take off and go to $100 per share and you would lose $70 per share in a short, however, the FAZ is a $9 stock and can only go to zero. For this reason, shorting both of these stocks, while profitable over a long period of time, could produce steep losses if the market moved quickly in any one direction.

Does that help explain a little better than I was?


Quote
The point is simply that in portfolio C, I can easily replicate a portfolio that is, BY DEFINITION "The return of portfolios A and B, multiplied by 2" - WHATEVER diversified or other portfolio you want to make A and B in the first place. Maybe it's stocks. Maybe it's a balanced portfolio. Maybe I recreate it with leveraged funds. Maybe I recreate it with options. The point remains, ANY portfolio you create in scenario A and B, I can create in scenario C without debt, by owning more volatile stuff or synthetically creating more volatile stuff with options. Which again, lets me get the same returns, WITHOUT debt leverage.

Can we conclude that this is an oversimplification?

Absolutely.
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velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #24 on: June 23, 2012, 04:41:51 AM »

Bank

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Re: Pay off mortgage or invest (revisited)
« Reply #25 on: June 23, 2012, 06:23:14 AM »
Thanks --- in other words, no free (or at least risk-free) lunch.  Here's another article on some of the potential downsides of ETF's I read in The Economist a few months ago.  Since it's long, here's one of the more interesting passages:  http://www.economist.com/node/21547989

"But there is a slice of the ETF market, making up a little over 10% of global assets under management and concentrated in Europe, that is “synthetic”. This means that the returns generated by the fund come from a swap with a counterparty, often an affiliate of the fund manager. Instead of using investors’ cash to buy the underlying securities, the money is put into a basket of collateral whose returns are swapped with a counterparty for the returns of the index being targeted.

That spooks plenty of people because it exposes investors to counterparty risk. If the swap counterparty defaults, that leaves the investor holding the contents of the collateral basket as security. This collateral may not bear even a passing resemblance to the assets that the ETF is ostensibly tracking. And some regulators worry that banks purposely choose synthetic structures so that they can dump their illiquid assets into the collateral basket and get funding that they otherwise could not."

I don't invest in many ETF's and the ones I have are plain vanilla.  So maybe this isn't news to you, but it was to me.

velocistar237

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Re: Pay off mortgage or invest (revisited)
« Reply #26 on: June 23, 2012, 07:13:24 AM »
This is all new to me, and I have a lot to chew on from this thread. One thing is for sure; I need to be more responsible and go read the prospectuses for all the funds I hold.

arebelspy

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Re: Pay off mortgage or invest (revisited)
« Reply #27 on: June 23, 2012, 08:27:17 AM »
These links tie it up nicely. Thanks.

Cool.  I knew I wasn't explaining it correctly, glad those helped get across what I was trying to say.
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