Leverage

[chasingthegoodlife]

Do you use it?

How do you feel about it - emotionally?

Do you have a 'rule of thumb' about how much you're comfortable with?

Would you only use leverage for certain asset classes? Or with a certain loan structure? (e.g. margin loan vs secured against residential property).

Lately I find myself pondering the psychology of it.

My partner and I have 2 IPs that were originally our respective PPORs. The original borrowing wasn't made with investment in mind and we've held them for a long time so the LVR is low.

At times I think we should be making more use of leverage. We could easily borrow against our PPOR or one of the IPs at a low rate (for now anyway) and invest in an ETF like VAS that pays distributions and would have minimal impact on cashflow.

On the other hand, there's something about borrowing to buy stocks in such a buoyant market that feels risky and irresponsible.

Yet if we had an 80% LVR on the IPs I know we would be investing in ETFs rather than paying off those loans. Which is sort of the same result.

Not so much looking for advice as keen to hear how everyone else approaches this for themselves (though feel free to hit me with your opinion anyway!).

[MustacheAndaHalf]

What do you think about leveraged ETFs?

The most famous is UPRO (U.S. S&P 500 3x).  Buying shares of UPRO is like borrowing 200% of assets on margin, and paying the margin loan for 2x your account balance.  Leveraged ETFs aren't cheap, but their 1% expense ratio tends to be cheaper than taking out a margin loan.

I've seen a number of brokerages offering 8% or so margin loans.  They also use a traditional "margin call" model, where they warn you before selling your assets.  I think Interactive Brokers uses a more aggressive approach, where their computers watch the market and can liquidate you without warning.  That sounds bad, but I think that's why they can offer much lower rates (1.59% for the first $100k).

Last year, I took out my first margin loan to buy index ETFs.  Before doing that, I looked at worse case past scenarios.  If something like the 2008 financial crisis occurs again, how do I avoid multiplying a 50% loss?  Or even the great depression, with 90% losses?  The short answer is "accept when you're wrong".  If my account had taken -20% losses, I would have started to sell assets at a loss to pay off the margin loan.  It turned out fine, but I wasn't willing to invest in borrowed assets until I knew how it could go wrong.

[chasingthegoodlife]

I don't feel I know enough about leveraged ETFs to make an educated decision. Definitely something to read up on a little more.

For us, if we did decide to borrow further funds to invest in shares we would almost certainly use a loan secured against our (currently fully offset) PPOR. So similar to a debt recycling strategy only we are starting from a paid off home and probably moving into the market in 1-3 big chunks rather than DCA-ing in over a more extended period as we pay down the PPOR balance.

The rate would be a lot lower than most margin loans, but most importantly we wouldn't risk having to sell in a falling market.

In a 2008 type scenario we could easily hold until recovery (much easier to say for a recent crash because I know our actual work histories over that time). Assuming that we bought in at the pre crash peak in Sept 2007,  accounting for the holding costs it would have been a pretty average investment. But buying in a few years earlier or a few years later would have given a much more attractive rate of return.

(This was a great thought exercise by the way - thank you. I found this calc useful for modelling the returns for different entry and exit points: https://www.noelwhittaker.com.au/resources/calculators/stock-market-calculator/ ).

A great depression scenario is much harder to predict because it would potentially impact on all the other areas of our lives (would we be able to get tenants for our IPs, would our govt funded jobs be affected by austerity measures? etc etc). I'm sure we'd regret the decision to borrow more to invest, but then again we'd also regret that we'd been investing our income rather than paying off the rest of the (small, low interest) loans against our IPs. Which 'feels' much too conservative for me right now.

You said that for you personally you would sell when you hit a 20% loss - would you also do this for shares you owned outright? Or is this solely about limiting the risk of a forced sale/margin call? Does your anticipated time to retirement factor into this decision at all?

My strategy is to hold through dips (resolve only tested by the March 2020 covid crash thus far, with no lost sleep) and I had assumed I would approach any new investment the same way but curious to hear how others think about it. 

[MustacheAndaHalf]

If you can get a low cost loan on from your property, there's no "margin call" involved with that.  The dynamics are very different when you borrow against assets.  If the property loan is comfortably low, that can be worth it.

I bought leveraged ETFs like "GUSH" (leveraged oil ETF) at Interactive Brokers (IBKR has a Sydney office).  Before I bought it, it took losses during a volatile time in 2020, and reduced it's leverage from 3x to 2x.  Leverage was too expensive for the ETF.  That means some people took 3x losses, but then only had 2x leverage on the gains.  And some leveraged oil ETFs did worse than that - they collapsed, and gave back pennies on the dollar after huge leveraged losses.

Note that I've been exiting leveraged ETFs - I only bought them to ride leverage through a recovery.  Now I'm back to a total world index fund allocation (split into U.S. + international to save on expense ratios, and let me rebalance).

One counterintuitive thing about investing with borrowed money - you should also have some cash in reserve.  You're paying interest on borrowed money, but also need an emergency fund in cash.

[marty998]

One aspect oft forgotten is that the companies you’re invested in via a normal ETF are already leveraged. Companies have borrowings just like you and me.

Now if you buy these leveraged ETFs using a margin loan or other borrowed money then you’ve got debt on debt on debt.

That’s what I find really scary. It’s starting to really grate on me on all the FIRE forums I see that the discussion seemingly tends towards only investing in high risk, high growth options using max leverage all the time, because that’s the optimal mathematical outcome over the long term.

It fails to take into account the seemingly random life incidents that can befall you over the long term.

In one year you might have the perfect life where everything goes to plan. You think you can keep that up over 5 years? 10 years? 25 years? Keep your career, avoid divorce, cancer, accidents, chronic illness, addictions, cyber fraud against you, inheritance drama, interest rates going to the moon, short holidays that might leave you stranded overseas in a pandemic etc etc etc.

It’s a charmed life where one can avoid all of this AND take a very high risk approach to investing AND be successful at the end of it.

Now having said that, I’m ok with the initial strategy as outlined - debt recycle against the PPOR, but I would be paying it off. I hate the idea of carrying debt forever - pay it down so you have your firehose of cash in ER.

Personally though, I think the average punter, which covers 99% of people, should be banned from buying leveraged ETFs. It’ll ruin most people.

[mjr]

How do I feel about leverage on equities ?

Would never touch it.  That's how people get wiped out.  Sure, I'll never make a quick fortune, but I don't need to make a quick fortune.

In the next big crash, I'm likely to watch my portfolio drop in value by a million dollars.  That's going to be hard to watch, but I'll get through it.  With leverage in the picture, every chance I'd go out the back door.

I like sleeping at night too much.

Also, what Marty said.

[chasingthegoodlife]

Thanks mjr and marty - appreciate your thoughts.

That’s what I find really scary. It’s starting to really grate on me on all the FIRE forums I see that the discussion seemingly tends towards only investing in high risk, high growth options using max leverage all the time, because that’s the optimal mathematical outcome over the long term.

It fails to take into account the seemingly random life incidents that can befall you over the long term.

In one year you might have the perfect life where everything goes to plan. You think you can keep that up over 5 years? 10 years? 25 years? Keep your career, avoid divorce, cancer, accidents, chronic illness, addictions, cyber fraud against you, inheritance drama, interest rates going to the moon, short holidays that might leave you stranded overseas in a pandemic etc etc etc.

I hear you. I think a lot of new investors are in for a shock over the next prolonged downturn. And the number of 'sell everything and put it in crypto' type comments I've seen lately is mind boggling.

For my own situation, I can see in retrospect that making more use of leverage instead of paying down PPOR debt over last last 6 years would have been optimal financially but I don't feel confident leveraging up now is the right choice.

When I think about the amount we'd be comfortable borrowing and model it out using average returns over the next ten years the return just ... doesn't seem worth it. And that's assuming interest rates remain low, which is a huge assumption over that time span.

Perhaps I'd feel differently if we were younger or in the early stages of accumulation or had higher salaries. 

All going well with our current plans/portfolio my husband will be retired and I'll be work optional before those 10 years are up anyway. As you say things rarely go exactly to plan over that long a horizon, so is the chance of a modest increase to the stash worth the risk of having our options constrained in any way by borrowing more?

Am I just bored with the 'set and forget' stage and trying to over optimise? :)

Leaving this option on the backburner for further consideration.

(For anyone else pondering this for themselves, I used the assumptions HERE https://cashflowco.com.au/debt-recycling-a-step-by-step-guide-to-smashing-debt-and-building-passive-income/ as a starting point for modelling my own situation. As I said above, I think the interest rate one is overly optimistic).