Author Topic: Indexing with leverage  (Read 44420 times)

josstache

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Indexing with leverage
« on: March 17, 2015, 09:48:39 AM »
It seems to me the reason real estate can be such a good investment is because of the cheap leverage available.  Without that, real estate's "1% rule" gives you a 6% annual return after assumed expenses of 50% of your gross rent, and 6% is less than one expects from the stock market on average. (Though I am aware some markets have a 2% rule, which is clearly much better.)

I don't particularly want to be a landlord.  I'd rather index with my own leverage if possible.  Leveraged ETFs are no good because they don't seem suited for long-term holdings given they aim to amplify daily returns (and can thus take your investment to zero even if the benchmark is going sideways).  My minimal research has turned up the availability of secured loans for stocks, but those appear to carry rates of 6% or higher, which would eat up most of the expected returns in any long-term indexing strategy.  Brokers' margin interest seems to be similarly high. 

I don't understand options very well, but would they be an option (pun intended)?  Is there another solution I'm not aware of? 

arebelspy

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Re: Indexing with leverage
« Reply #1 on: March 17, 2015, 09:54:16 AM »
The advantage of RE leverage is it's typically fixed rate (no worries about it adjusting on you), and, even more important, the term is 15, 20, or 30 years.  They can't call it on you if you're making your payments.

Margin calls in a dip will ruin someone.

Give me a 30-year margin loan on equities at today's interest rates and I'll absolutely take it to invest in index funds (and that's exactly what I'm doing when I'm investing in index funds rather than paying off my mortgages).

But a short term margin loan they can call at the worst possible time, forcing me to sell low, right when I want to be buying more?  No thanks.

There are other threads discussing this, if you run a search you should find some discussion.  IIRC 2x leverage outperforms over time, but obviously increases your volatility. 
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Re: Indexing with leverage
« Reply #2 on: March 17, 2015, 09:56:18 AM »
Broker margin interest runs about 1.6% at Interactive Brokers right now. 

I am very happy with (and recommend at my blog) MORL which is a 2X leveraged REIT basket.  The re-balancing is down monthly instead of daily so the tracking error is small.  http://www.nasdaq.com/symbol/morl/dividend-history has the distribution history and spot price if you are interested.  I think it makes sense to use half the normal position size as you have twice the risk of capital depreciation.  I get 21.77% yield based on annualizing the most recent quarter's distribution versus spot price. 

josstache

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Re: Indexing with leverage
« Reply #3 on: March 17, 2015, 10:37:46 AM »
That's good to know on Interactive Brokers.  If using margin, I don't think I'd be looking at 50% LTV.  Even that puts you at risk of having to sell if we manage a repeat of the financial crisis.  But it seems that something like 15% LTV would be relatively safe even from another 1929 and still provide some boost to returns, though the question then is whether it would outperform the broker's other fees at lower account sizes.

johnny847

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Re: Indexing with leverage
« Reply #4 on: March 17, 2015, 11:06:02 AM »
Margin calls in a dip will ruin someone.
...
But a short term margin loan they can call at the worst possible time, forcing me to sell low, right when I want to be buying more?  No thanks.

You got that right. This thread is always fun to read now that we have the power of 20/20 hindsight. https://www.bogleheads.org/forum/viewtopic.php?p=73329

arebelspy

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Re: Indexing with leverage
« Reply #5 on: March 17, 2015, 11:09:51 AM »
Margin calls in a dip will ruin someone.
...
But a short term margin loan they can call at the worst possible time, forcing me to sell low, right when I want to be buying more?  No thanks.

You got that right. This thread is always fun to read now that we have the power of 20/20 hindsight. https://www.bogleheads.org/forum/viewtopic.php?p=73329

Oh god, I just opened and looked at the date of the first post (Sun Sep 16, 2007) and shuddered.

This is gonna be a rough one - I'm imagining a "can't look away trainwreck" type scenario..  =/

The article linked to makes some good points though: http://www.whynot.net/main/mortgage_retirement.pdf

But that's why I'd leverage up on mortgage debt where possible.

EDIT: Another thread when he gets a margin call, linked partway through: http://www.bogleheads.org/forum/viewtopic.php?f=10&t=11742

I like this guy.  He's calm, rational, makes good arguments, and doesn't get defensive.  I feel bad for him.

EDIT 2: Someone named "ralphjones" posted this:
Quote
Before I fought Marvin Hagler in Vegas in '85 my trainer believed in intra temporal risk reduction - he'd arranged for Hagler's punches to be spread over a lifetime rather than concentrated in a few rounds of boxing.

'You dont want to put it all at risk over a short period and get hit with a flurry of punches in a few seconds - better to spread it over your entire life. Sure it may hurt - but you'll have time to recover. Statistically you will, on average, end up with a better result. Trust me.'

When I was 8 years old a left hook from Marvin Hagler caught me flush on the temple.

20 years later I still hadn't recovered and had to pull out of the fight [Tommy Hearns, bless him, stepped in for me]. My trainer was unapologetic - 'I've looked at Haglers weighted punch distribution and you were so unlucky to get caught so early'

Hearns went down to a flurry of punches in the third, so I guess my trainer was right after all.

Beautiful. 

EDIT3:
Quote
If there were a Darwin Award for Economics, MT would be a shoo-in.

EDIT4: For those who want to skip to a summary post after, this is a good one: https://www.bogleheads.org/forum/viewtopic.php?p=432493#p432493

EDIT5: And final conclusions, after the blowup was over and the working his way out of debt was over:
Written in 2012:
Quote
Yes, I went positive in May 2011. Currently, I’m at somewhere around $220K, not counting my wife’s assets. This has all been from savings and gains from short term trading, not due to the rally in stocks. I was forced to stop mortgaging my retirement in March 2009. If all goes well, we’ll reach financial independence, having enough passive income to cover our living expenses, in about 2.5 years. It would be great to start parenthood without being required to have a job, though I expect to continue working into old age. I’ve been exceedingly fortunate for the past three years and am taking nothing for granted.

Feb 2013:
Quote
Net worth has steadily climbed to $350K since the Q4 2008 trough of -$210K. The past few years have been spent dealing with the consequences of going so far into debt, while trying to move on with life in the direction that had been planned pre-crash. I married Borte (mentioned earlier in thread), finished my PhD, and am about to become an expat in Southeast Asia.

And finally, Feb 2015, a month ago:
Quote
I just noticed it's been two years since I posted an update.

Equity exposure: $200K
Net worth: $700K, up $910K since Q4 2008

Since 2005, my goal has been to trade for a living. As a grad student at the time, I read about people like Soros and Niederhoffer, and thought I could achieve similar success. Once I decided on this path, there was no career that could compare to the excitement and intellectual challenge of trading. The search for truth in markets is even more pure than in academia. Around that time, I essentially abandoned my formal education to trade--first event derivatives for two years (with much success) and then equities (where I blew up quickly). I came to appreciate the volatility of markets and unreliability of myself in 2008, and then developed and refined some strategies in the years that followed. For most of the past year, I've been "retired," which is to say my only source of income comes from my investments. Where I am now--having some risk capital, getting to live with my wife and son--is a vision that carried me through some dark days several years ago, when I was alone and broke. In total, I spent seven years apart from my wife, nearly the entire duration of this thread, saving the money to make this vision a reality. Now I just can't blow it.

Like I said before, I like the kid.  I hope he does well.
« Last Edit: March 17, 2015, 11:54:56 AM by arebelspy »
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johnny847

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Re: Indexing with leverage
« Reply #6 on: March 17, 2015, 11:47:13 AM »
Oh god, I just opened and looked at the date of the first post (Sun Sep 16, 2007) and shuddered.

This is gonna be a rough one - I'm imagining a "can't look away trainwreck" type scenario..  =/

The article linked to makes some good points though: http://www.whynot.net/main/mortgage_retirement.pdf

But that's why I'd leverage up on mortgage debt where possible.

EDIT: Another thread when he gets a margin call, linked partway through: http://www.bogleheads.org/forum/viewtopic.php?f=10&t=11742

I like this guy.  He's calm, rational, makes good arguments, and doesn't get defensive.  I feel bad for him.

EDIT 2: Someone named "ralphjones" posted this:
Quote
Before I fought Marvin Hagler in Vegas in '85 my trainer believed in intra temporal risk reduction - he'd arranged for Hagler's punches to be spread over a lifetime rather than concentrated in a few rounds of boxing.

'You dont want to put it all at risk over a short period and get hit with a flurry of punches in a few seconds - better to spread it over your entire life. Sure it may hurt - but you'll have time to recover. Statistically you will, on average, end up with a better result. Trust me.'

When I was 8 years old a left hook from Marvin Hagler caught me flush on the temple.

20 years later I still hadn't recovered and had to pull out of the fight [Tommy Hearns, bless him, stepped in for me]. My trainer was unapologetic - 'I've looked at Haglers weighted punch distribution and you were so unlucky to get caught so early'

Hearns went down to a flurry of punches in the third, so I guess my trainer was right after all.

Beautiful. 

EDIT3:
Quote
If there were a Darwin Award for Economics, MT would be a shoo-in.

EDIT4: For those who want to skip to a summary post after, this is a good one: https://www.bogleheads.org/forum/viewtopic.php?p=432493#p432493

Haha yea I skimmed through some of the posts. I found a couple where MT said something along the lines of..."OMG FOR CHRIST'S SAKE STOP TRADING ALREADY!" (well maybe not as emphatically...but you can imagine his panic).

What I found the most interesting is that some people on Bogleheads agreed with most of his ideas. I think one guy said it was a good plan but poorly implemented---if he had used uncallable debt, such as RE leverage, perhaps MT would have been okay.

arebelspy

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Re: Indexing with leverage
« Reply #7 on: March 17, 2015, 11:56:14 AM »
What I found the most interesting is that some people on Bogleheads agreed with most of his ideas. I think one guy said it was a good plan but poorly implemented---if he had used uncallable debt, such as RE leverage, perhaps MT would have been okay.

I think it's a good idea too, executed at the worst possible time.  And even in the end where he lost 200k, that compared to his lifetime earnings is fairly small.  Many times something like it could work.

I don't need to take on the risk, but I can see why one would want to.
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arebelspy

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Re: Indexing with leverage
« Reply #8 on: March 17, 2015, 11:58:25 AM »
Apparently we have a "market timer" on these forums, and based on previous posts (mentioning wife and kid), it sounds very likely it's the same person (or a large coincidence).

Sending him a PM linking to this thread.  Given how transparent/honest he was over at BH, I'd bet he'll chime in if it is him.
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SuperSecretName

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Re: Indexing with leverage
« Reply #9 on: March 17, 2015, 12:07:26 PM »
you might be interested in reading this (ongoing) thread:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=143037

Kaspian

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Re: Indexing with leverage
« Reply #10 on: March 17, 2015, 12:24:56 PM »
You know, I've been thinking of doing this recently?  (Not too seriously, more as in 'lightly musing'.)  It's tempting that my bank has given me with a line of credit of $15,000 with 4.75% interest.  If things went the way they have in the past few years and I make 10%, that'd be a clean $787 profit.  Very good chance I'd make more than a 4.75% return in any case.  However, the very thought of paying off a loan monthly (shudder!) rather than DCA-ing in fresh cash, turns me off.  Not enough incentive to try (gamble) for $800 anyway.  Hell, my portfolio swings more than that on any given day.  So, forget it for now.

beltim

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Re: Indexing with leverage
« Reply #11 on: March 17, 2015, 01:18:10 PM »
I don't understand options very well, but would they be an option (pun intended)?  Is there another solution I'm not aware of?

You can buy LEAPS (Long-term Equity AnticiPation Securities) on an S&P 500 ETF.  I think you can always get them at least two years out – the last dated one I see are December 2017.  Buy buying LEAPS with a strike price at half the current price, you're effectively getting 2X margin.  So for the December 2017 LEAPS of SPY (an S&P 500 ETF), strike price 105, you'd pay about 103-104.  So your effective margin rate would be just about equal to the S&P 500 dividend yield (since owners of options don't receive dividends), or about 1.9%.

Advantages of this strategy:
•no margin calls
•margin rate reasonable (in this example, pretty much just the forgone dividends)
•can guarantee no short-term taxable events (for taxable accounts)
•can do within an IRA

Disadvantages:
•term-limited, so you have to sell and re-buy every 2-3 years, leading to transaction costs (pretty minor, actually), and capital gains (in a taxable account)
•have to find a broker willing to let you buy options in an IRA (common, but also common for brokerages to not allow this)
•don't collect dividends from underlying investment

You can do something similar with a futures product called E-minis, but those are available at fewer brokerages.

beltim

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Re: Indexing with leverage
« Reply #12 on: March 17, 2015, 01:19:06 PM »
Oh, and a great book on this subject is called Lifecycle Investing by Barry Nalebuff and Ian Ayres.

hodedofome

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Re: Indexing with leverage
« Reply #13 on: March 17, 2015, 01:30:03 PM »
I  haven't read the bogleheads thread yet (TL:DR), but if someone put a gun to my head this is what I would do:

1) Buy index futures, it offers an incredible amount of leverage with no interest rate cost. Only costs are trading commissions.

2) Interactive brokers charges roughly $2 a trade commission per futures contract https://www.interactivebrokers.com/en/index.php?f=commission&p=futures1

3) Right now the S&P 500 is at 2066. The e-mini S&P 500 contract size is $50 x S&P 500 price http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500_contract_specifications.html That means the contract is worth $103,300

4) Each point of the S&P 500 is worth $50. That means if you buy 1 contract and the price of the S&P goes down by 5 points, you just lost $250.

5) The margin requirement (currently) of the e-mini S&P 500 contract at Interactive Brokers is $4,600. If you have a $5,000 account and buy 1 e-mini S&P contract, if your account gets to or below $4,600 they will automatically sell you out of your position. With only $400 difference that's only 8 S&P points, not much room for error!

6) But if your account was $50,000, and you bought 1 contract controlling $103,300 worth of the index, that's 2X leverage and no interest to pay. For you to get margin called, you'd have to lose $45,400. That's 908 points for the S&P 500 to lose before you're stopped out (and you've basically lost all your money....).

7) Because that's about a 50% loss for the S&P, if we had another financial crisis or whatever you could lose all your money if today is the top. THAT'S WHY YOU ONLY DO THIS IF THE INDEX IS DOWN HARD. I'd wait for at least a 20% pullback before attempting this. That would increase the odds that the S&P won't fall enough to give you a margin call.

The problem would be that the exchanges can increase the margin whenever they want. If they increased the margin to $10k, then that's less points the S&P has to go down before giving you a margin call. Another issue is that the contracts expire every so often, and you have to sell the contract and buy another one out in the future. That increases your commissions and also creates a bit of slippage. The spread/tick is .25/point so the bid price is 2066.00 but the ask is 2066.25. If you sell, you have to sell at 2066, if you buy, you have to buy at 2066.25. So you're gonna give up at least .25 a point every time you 'roll' a contract as it's called. This may not sound like much but it adds up over time. If you just leverage up an ETF, you could hold onto it indefinitely and never have to sell it, reducing the slippage to nothing.

arebelspy

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Re: Indexing with leverage
« Reply #14 on: March 17, 2015, 01:45:07 PM »
7) Because that's about a 50% loss for the S&P, if we had another financial crisis or whatever you could lose all your money if today is the top. THAT'S WHY YOU ONLY DO THIS IF THE INDEX IS DOWN HARD. I'd wait for at least a 20% pullback before attempting this. That would increase the odds that the S&P won't fall enough to give you a margin call.

That was a large part of what hurt market timer - catching a falling knife.

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beltim

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Re: Indexing with leverage
« Reply #15 on: March 17, 2015, 01:52:11 PM »
7) Because that's about a 50% loss for the S&P, if we had another financial crisis or whatever you could lose all your money if today is the top. THAT'S WHY YOU ONLY DO THIS IF THE INDEX IS DOWN HARD. I'd wait for at least a 20% pullback before attempting this. That would increase the odds that the S&P won't fall enough to give you a margin call.

That was a large part of what hurt market timer - catching a falling knife.

One of the most interesting parts of the book I recommended above was that the strategy of using leverage still works even when you reduce your equity exposure in a market downturn.  That is, if the market falls 25%, you're better off rebalancing so that you're still only 2X leveraged (so you'd have to sell half of your position).  It's a much lower risk strategy than the one posted on bogleheads.

arebelspy

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Re: Indexing with leverage
« Reply #16 on: March 17, 2015, 01:59:35 PM »
7) Because that's about a 50% loss for the S&P, if we had another financial crisis or whatever you could lose all your money if today is the top. THAT'S WHY YOU ONLY DO THIS IF THE INDEX IS DOWN HARD. I'd wait for at least a 20% pullback before attempting this. That would increase the odds that the S&P won't fall enough to give you a margin call.

That was a large part of what hurt market timer - catching a falling knife.

One of the most interesting parts of the book I recommended above was that the strategy of using leverage still works even when you reduce your equity exposure in a market downturn.  That is, if the market falls 25%, you're better off rebalancing so that you're still only 2X leveraged (so you'd have to sell half of your position).  It's a much lower risk strategy than the one posted on bogleheads.

Interesting.  Psychologically I think I'd have trouble with that.. I'd want to "get it back."  Good to know though.
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beltim

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Re: Indexing with leverage
« Reply #17 on: March 17, 2015, 02:01:45 PM »
One of the most interesting parts of the book I recommended above was that the strategy of using leverage still works even when you reduce your equity exposure in a market downturn.  That is, if the market falls 25%, you're better off rebalancing so that you're still only 2X leveraged (so you'd have to sell half of your position).  It's a much lower risk strategy than the one posted on bogleheads.

Interesting.  Psychologically I think I'd have trouble with that.. I'd want to "get it back."  Good to know though.

Yes, I felt the same way before reading.  At the same time, though, "getting it back" for me would be to stay at the same leverage, instead of increasing it like market timer.

theoverlook

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Re: Indexing with leverage
« Reply #18 on: March 17, 2015, 02:41:35 PM »
Oh, and a great book on this subject is called Lifecycle Investing by Barry Nalebuff and Ian Ayres.

Market timer's case and the thread on Bogleheads was discussed in that book, and he mentions it in the thread.

Financial.Velociraptor

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Re: Indexing with leverage
« Reply #19 on: March 17, 2015, 02:51:14 PM »
That's good to know on Interactive Brokers.  If using margin, I don't think I'd be looking at 50% LTV.  Even that puts you at risk of having to sell if we manage a repeat of the financial crisis.  But it seems that something like 15% LTV would be relatively safe even from another 1929 and still provide some boost to returns, though the question then is whether it would outperform the broker's other fees at lower account sizes.

Note that IB will not issue a conventional "margin call".  If the computer detects you have a margin violation, it immediately begins liquidating positions to whatever extent necessary to bring you back into compliance.  Back when I was still employed and doing well, I figured "what could it hurt?" and tried it out.  I had a liquidation event when the news of the Greek crisis hit.  I went up over 6 figures in a period of about 4 months and lost it all back over a period of about 19 minutes.  I ultimately came out a few thousand ahead and fortunately learned a valuable lesson.  I now use very modest leverage in FIRE.

Leverage the raptor way:
1) sell a cash secured put; use the proceeds to buy a call (alternatively an OTM call for a net credit).  This is called a "synthetic long" you get the same exposure to upside/downside as going long the underlying security but you are out no cash.  Your leverage (if you choose to use it 5:1) - and no margin interest.
2) write "diagonal calls".  You buy a very deep in the money far dated call (this should have just a few cents of time value on it) and write short term covered calls a couple strikes out.  The ITM long call hedges your exposure to the (naked) short call and gives you leveraged exposure to upside growth.  (you may have to put more money into the trade to buy back any short calls that go ITM) [your leverage - about 3:1 for most deep ITM LEAPS]  Recommended only for big slow moving blue chips - I have a well performing one open on Pepsico.
3) short with "synthetic shorts".  I have done this many times with UVXY and other volatility tracking indexes.  To do this, you write a naked call and use the proceeds to buy a long put.  Same exposure to price upside/downside as a conventional short but your shares can't be called away in a squeeze.  Leverage is hard to calculate here because it is indexed to how far the call is in or out of the money.  Anywhere from trivial to Holy Smoke!  Wear gloves if you decide to play with this fire.

A friendly reminder, going short including synthetic short, can be very destructive.  Use rational position sizing or face the consequences.

Indexer

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Re: Indexing with leverage
« Reply #20 on: March 17, 2015, 03:54:06 PM »
Leveraged ETFs are no good because they don't seem suited for long-term holdings given they aim to amplify daily returns (and can thus take your investment to zero even if the benchmark is going sideways).  My minimal research has turned up the availability of secured loans for stocks, but those appear to carry rates of 6% or higher, which would eat up most of the expected returns in any long-term indexing strategy.  Brokers' margin interest seems to be similarly high. 

I don't understand options very well, but would they be an option (pun intended)?  Is there another solution I'm not aware of?

Well first lets cover leverage in real estate and leverage in the market are very different.  Houses normally don't fluctuate a lot in value.  2008 was more an exception than the rule.  Stocks do bounce around.  2008 wasn't 'normal' but it also wasn't far out of the ordinary for what can happen in a bear market. 

Keep in mind when you go on margin earnings are boosted, but so are loses, and if you run into a margin call things can get ugly quick.  You either have to add to the account, or the broker is going to liquidate your securities to cover the difference. 


I could understand 'not paying off a low interest debt' so you could instead put more in the market.

Rule #1 with options.  If you don't understand them very well don't touch them.
Rule #2  Its a zero sum game.  For every person with positive returns there is someone with negative.  You are making a bet against another person.

I heard a quote once about margin and options from a CFP.  "The only people who should ever use margin or options are the people who are smart enough not to."

jmusic

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Re: Indexing with leverage
« Reply #21 on: March 17, 2015, 05:09:39 PM »
I don't understand options very well, but would they be an option (pun intended)?  Is there another solution I'm not aware of?

You can buy LEAPS (Long-term Equity AnticiPation Securities) on an S&P 500 ETF.  I think you can always get them at least two years out – the last dated one I see are December 2017.  Buy buying LEAPS with a strike price at half the current price, you're effectively getting 2X margin.  So for the December 2017 LEAPS of SPY (an S&P 500 ETF), strike price 105, you'd pay about 103-104.  So your effective margin rate would be just about equal to the S&P 500 dividend yield (since owners of options don't receive dividends), or about 1.9%.

Advantages of this strategy:
•no margin calls
•margin rate reasonable (in this example, pretty much just the forgone dividends)
•can guarantee no short-term taxable events (for taxable accounts)
•can do within an IRA

Disadvantages:
•term-limited, so you have to sell and re-buy every 2-3 years, leading to transaction costs (pretty minor, actually), and capital gains (in a taxable account)
•have to find a broker willing to let you buy options in an IRA (common, but also common for brokerages to not allow this)
•don't collect dividends from underlying investment

You can do something similar with a futures product called E-minis, but those are available at fewer brokerages.

The trouble with LEAPS is similar to futures:  Not only are you buying "equity" you're also buying time value, which goes down over time.  So there's three possible scenarios:

1.  Market goes up a LOT (>20%).  Result = profit.
2.  Market is somewhat higher (5-15%).  Result = breakeven while watching the market go higher!
3.  Market is flat to lower.  Result = loss while market is flat, BIG loss if lower.

hodedofome

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Re: Indexing with leverage
« Reply #22 on: March 17, 2015, 06:05:02 PM »

Leveraged ETFs are no good because they don't seem suited for long-term holdings given they aim to amplify daily returns (and can thus take your investment to zero even if the benchmark is going sideways).  My minimal research has turned up the availability of secured loans for stocks, but those appear to carry rates of 6% or higher, which would eat up most of the expected returns in any long-term indexing strategy.  Brokers' margin interest seems to be similarly high. 

I don't understand options very well, but would they be an option (pun intended)?  Is there another solution I'm not aware of?

Well first lets cover leverage in real estate and leverage in the market are very different.  Houses normally don't fluctuate a lot in value.  2008 was more an exception than the rule.  Stocks do bounce around.  2008 wasn't 'normal' but it also wasn't far out of the ordinary for what can happen in a bear market. 

Houses aren't as volatile as stocks because they aren't daily quoted. If your house was traded on an exchange with daily prices I'd bet it would be just as volatile as a stock. It's only because we get a market price at the time that we sell many years later that we assume it was a smooth ride from point A to point B.

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Re: Indexing with leverage
« Reply #23 on: March 17, 2015, 06:17:20 PM »
I don't understand options very well, but would they be an option (pun intended)?  Is there another solution I'm not aware of?

You can buy LEAPS (Long-term Equity AnticiPation Securities) on an S&P 500 ETF.  I think you can always get them at least two years out – the last dated one I see are December 2017.  Buy buying LEAPS with a strike price at half the current price, you're effectively getting 2X margin.  So for the December 2017 LEAPS of SPY (an S&P 500 ETF), strike price 105, you'd pay about 103-104.  So your effective margin rate would be just about equal to the S&P 500 dividend yield (since owners of options don't receive dividends), or about 1.9%.

Advantages of this strategy:
•no margin calls
•margin rate reasonable (in this example, pretty much just the forgone dividends)
•can guarantee no short-term taxable events (for taxable accounts)
•can do within an IRA

Disadvantages:
•term-limited, so you have to sell and re-buy every 2-3 years, leading to transaction costs (pretty minor, actually), and capital gains (in a taxable account)
•have to find a broker willing to let you buy options in an IRA (common, but also common for brokerages to not allow this)
•don't collect dividends from underlying investment

You can do something similar with a futures product called E-minis, but those are available at fewer brokerages.

The trouble with LEAPS is similar to futures:  Not only are you buying "equity" you're also buying time value, which goes down over time.  So there's three possible scenarios:

1.  Market goes up a LOT (>20%).  Result = profit.
2.  Market is somewhat higher (5-15%).  Result = breakeven while watching the market go higher!
3.  Market is flat to lower.  Result = loss while market is flat, BIG loss if lower.

Considering I gave an actual quote on an option, your math is demonstrably wrong.

The breakeven point on the SPY quote I just gave was about 0.  So the only cost is foregone dividends (there is essentially no time value on these except for that).  If the market goes up 20%, the LEAP I mentioned would be up 40%.  The actual return would depend on the time period - on average, the foregone dividends would cost about 20% of the additional gains - so instead of 2x returns, you'd expect on average about 1.8x market returns.

hodedofome

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Re: Indexing with leverage
« Reply #24 on: March 17, 2015, 06:17:57 PM »
Back to the topic, when you start thinking about this stuff you'll probably find yourself down this road:

I want to increase my return over the market.

I don't want to lose all my money.

What if I leveraged up but added in uncorrelated asset classes that might do well when stocks are doing bad?

Ok lookie at these treasury bonds here, they seem to rise when stocks fall. I'll buy 50/50 stocks and bonds, leverage it up 2x and now I won't have to worry about margin calls. I might lower my return a bit but I'll increase the chance of not blowing up.

6 months later...well crap, I looked at some charts of stocks and bonds in the 1970s and realized it's possible for stocks and bonds to fall at the same time. Looks like it's still possible for me to lose all my money.

But wait! Inflation was rampant during that time so gold did fantastic. I'll add gold to my portfolio and leverage the whole thing 2x again and I'll be covered no matter the environment! I'm such a genius.

6 months later...well, you know after thinking about it, I don't really enjoy the idea of losing half my money even if I avoid a margin call. I wonder if there's a way to sell an asset class before it crashes 50%. I could use some sort of objective rule like sell it if it goes below the 200 day moving average or something like that. Yeah, I'm a genius.

Before you know it you just spends a whole lotta time recreating the wheel. Richard Donchian was doing this back in the 50s. Trend following managed futures funds have been doing this since the 70s and Meb Faber got widespread appeal from his Ivy League portfolio book. A leveraged tactical asset allocation strategy is what he proposes in the book and white paper and I think it's a natural progression to this desire of getting above market returns but without blowing up in the process.

Summary: diversify across uncorrelated asset classes, buy the ones going up, sell the ones going down. Manage risk, always cover your butt.
« Last Edit: March 17, 2015, 06:55:40 PM by hodedofome »

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Re: Indexing with leverage
« Reply #25 on: March 17, 2015, 06:32:55 PM »
It'll take me some time to digest this thread, but that market timer thread did inspire me to apply some margin leverage.  It's low leverage with access to funds that can extinguish the debt, but there's still a bit of tail risk: my biggest concern is a flash crash that temporarily (just a few seconds?) causes quotes low enough for IB to liquidate my positions.  Not much recourse -- IB has a lot of leeway to screw you over.

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Re: Indexing with leverage
« Reply #26 on: March 17, 2015, 06:35:49 PM »
I'm fully in agreement with everyone preaching caution. This isn't something I would go out and do tomorrow, to be sure.  But the thread has already given me a lot of new ideas, and I'll definitely check out the book recommendations.

arebelspy

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Re: Indexing with leverage
« Reply #27 on: March 17, 2015, 08:31:18 PM »
It'll take me some time to digest this thread, but that market timer thread did inspire me to apply some margin leverage.  It's low leverage with access to funds that can extinguish the debt, but there's still a bit of tail risk: my biggest concern is a flash crash that temporarily (just a few seconds?) causes quotes low enough for IB to liquidate my positions.  Not much recourse -- IB has a lot of leeway to screw you over.

I'd love to hear more details about what you implemented (what you decided and why, especially regarding the amount versus the rest of your portfolio). 
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Re: Indexing with leverage
« Reply #28 on: March 17, 2015, 10:26:37 PM »
If you know what you're doing, you don't need it. if you don't know what you're doing, you definitely don't need it.

innerscorecard

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Re: Indexing with leverage
« Reply #29 on: March 18, 2015, 02:54:03 AM »
It's astounding that those some of those who believe in the cult of Bogle just can't wait and will even consider leveraging up on index funds with a straight face, yet any deviation into individual security selection is seen as completely outrageous and out of bounds.

Grog

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Re: Indexing with leverage
« Reply #30 on: March 18, 2015, 02:56:20 AM »
I've recently noticed this ETN from UBS:
http://www.morningstar.de/de/etf/snapshot/snapshot.aspx?id=0P00012JO6
http://www.google.com/finance?q=NYSEARCA%3ASPLX&ei=FDwJVZjHOcGPwAO0vYHgCw

It is not an ETF, it is an ETN (like MORL quoted above). It is similar to the leveraged ETF 2x 3x like USO but you get total return (leveraged ETF usually don't account for dividend) and it is reset monthly.
Before I'll start investing in it I want to understand the tax impication, but it does look bad, although ETN are far more riskier then ETF.

innerscorecard

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Re: Indexing with leverage
« Reply #31 on: March 18, 2015, 02:59:53 AM »
The reason I say that is because with systematic index investing, you are knowingly and purposefully buying assets in a completely price agnostic fashion. It's time that helps you, evening out purchases of assets when they are overvalued with purchases of assets when they are undervalued. Time heals your wounds, even when you don't buy at the best times.

You completely destroy that with leverage. You introduce systematic risk for no good reason.

Where leverage makes sense is, as arebelspy has said, when the terms make sense (as with mortgage debt), as well as, importantly, when you know that you are buying undervalued assets that will in fact rise, even because of certain catalysts. As is the case when you are buying undervalued individual securities, perhaps even in a way that hedges out market risk (although at a significant cost). You have the advantage of knowing exactly what you are buying, because you have done the valuation work. That's not the case at all with blind index investing. That only works when you can wait it out. And you can't do that with leverage.

I'm quite familiar with the arguments presented in Life Cycle Investing and other works, and they make a lot of sense at first. But they're not practical and don't really pass the smell test in the end. If you're so desperate to beat the market (and you shouldn't be, as a naive index investor), why are you at the same time so unwilling to do actual work to earn that extra return, whether it be by analyzing undervalued small cap stocks with no analyst coverage, or by networking and doing hard work in real estate?

You don't generally get something for nothing. Certainly not through leverage.

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Re: Indexing with leverage
« Reply #32 on: March 18, 2015, 07:31:14 AM »

You don't generally get something for nothing. Certainly not through leverage.

Agreed. The margin calls killed MT in that BH thread.

What about using a LOC to buy index funds during a market correction instead? That let's you gobble up some low cost equities in larger quantities than your day to day cash flow would allow without the brokerage being able to liquidate you.

Your creditor could ask you to repay the LOC, but even MT was getting fresh credit during the 2008 credit crisis so as long as you have work cash flow and/or home equity that may not be a real concern.

The LOC amounts I'd be thinking of say max $100K don't let a typical MMM mega saver type get super leveraged so maybe that's a natural safety mechanism.

--Vik

DrF

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Re: Indexing with leverage
« Reply #33 on: March 18, 2015, 09:30:45 AM »
If you want to reduce volatility/drawdown, get increased IRR, and protect your wealth then adding a leveraged ETF is a must.

Backtesting a portfolio with 20% ULPIX (2x S&P500) with 80% VBLTX (Vanguard long-term bond) beats a 100% SPY handily, and a 50% SPY / 50% VBLTX easily.

(Edit: Backtested using $1M with 4% SWR, rebalanced yearly.)

https://www.portfoliovisualizer.com/backtest-portfolio#analysisResults

Think what the reduced volatility/drawdown would be if you used ~10% UPRO (3x S&P500) with 90% VBLTX or similar.
« Last Edit: March 18, 2015, 09:32:22 AM by DrFunk »

arebelspy

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Re: Indexing with leverage
« Reply #34 on: March 18, 2015, 09:56:05 AM »

If you want to reduce volatility/drawdown, get increased IRR, and protect your wealth then adding a leveraged ETF is a must.

Wow!  Any other places I can get a free lunch?

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Re: Indexing with leverage
« Reply #35 on: March 18, 2015, 09:58:52 AM »

If you want to reduce volatility/drawdown, get increased IRR, and protect your wealth then adding a leveraged ETF is a must.

Wow!  Any other places I can get a free lunch?

Probably at your mom's house?

arebelspy

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Re: Indexing with leverage
« Reply #36 on: March 18, 2015, 10:01:07 AM »


If you want to reduce volatility/drawdown, get increased IRR, and protect your wealth then adding a leveraged ETF is a must.

Wow!  Any other places I can get a free lunch?

Probably at your mom's house?

Nope, strings are attached.  :)
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hodedofome

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Re: Indexing with leverage
« Reply #37 on: March 18, 2015, 10:04:00 AM »
Yeah what happens if bonds get killed in a rate increase. Your 80% allocation to long terms bonds may go down much further than your 40% allocation to US stocks.

What happens if there's another stagflation and both stocks and bonds go down at the same time? For an extended period of time?

This is why people start diversifying globally and across all sorts of asset classes (worldwide stocks, bonds, commodities, currencies, real estate). Diversification has historically been the only free lunch.
« Last Edit: March 18, 2015, 10:05:58 AM by hodedofome »

arebelspy

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Re: Indexing with leverage
« Reply #38 on: March 18, 2015, 10:07:47 AM »
Even diversification has drawbacks. Usually worth it, but it's still not a free lunch.
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hodedofome

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Re: Indexing with leverage
« Reply #39 on: March 18, 2015, 10:17:04 AM »
If you are using much leverage with volatile instruments then diversification is pretty much required. It's either that or you have to use market timing. Something has to protect the downside.

FWIW here's a 50/50 portfolio of 3X S&P 500 and 3X Long-Term Treasuries since inception (rebalanced annually). Too bad they don't go back BEFORE 2009. https://drive.google.com/file/d/0BzyyTlvGE-T2RUI4RndUU3JqZWc/view?usp=sharing

And here's a long/short futures strategy of the permanent portfolio. S&P 500, Gold, US 30-yr Bonds and US Dollar futures. Buy if the price is above the 50/200 day moving average (golden cross), sell short if the price is below the 50/200 day moving average (death cross). 1996-2015. There are no stops. Starts with $1 million in equity. https://drive.google.com/file/d/0BzyyTlvGE-T2YlhPblhsdy10aXc/view?usp=sharing
« Last Edit: March 18, 2015, 10:37:29 AM by hodedofome »

DrF

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Re: Indexing with leverage
« Reply #40 on: March 18, 2015, 10:19:00 AM »
Diversify all you want with that 80% AA, I'll stick with 10-20% 2x or 3x leveraged ETF.

arebelspy

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Re: Indexing with leverage
« Reply #41 on: March 18, 2015, 10:23:04 AM »
How does decay not ruin that plan?
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Re: Indexing with leverage
« Reply #42 on: March 18, 2015, 10:32:20 AM »
you keep talking about decay, decay is just price weakness that you can take advantage of when you rebalance (quarterly, semi-annual, annual - your preference).

at 10% AA for 3x or 20% AA for 2x, decay doesn't matter.

DrF

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Re: Indexing with leverage
« Reply #43 on: March 18, 2015, 10:35:28 AM »
i've noticed the awesome returns with tmf/upro also.

I'd never do 50/50, but maybe 10/10 tmf/upro with 80% diversified in 1x funds.

tmf may be an anomaly of the past 3-4 years.

hodedofome

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Re: Indexing with leverage
« Reply #44 on: March 18, 2015, 10:43:27 AM »
How does decay not ruin that plan?

We don't have enough data IMO to make a definitive judgement, however since the leveraged ETFs have been out the decay is very pronounced in commodities and other non-financial assets. However decay is much less pronounced in 'financial' assets like stocks and bonds. I attribute this to the lack of contango in S&P and bond futures. The tracking error doesn't seem to be horrible in the financials. That doesn't mean there can't be an environment where everything falls apart. I don't know what that would look like but I know there were several days in 2008 that the 2X ETF was significantly different than the nonleveraged one for SPY.

DrF

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Re: Indexing with leverage
« Reply #45 on: March 18, 2015, 10:52:13 AM »
How does decay not ruin that plan?

We don't have enough data IMO to make a definitive judgement, however since the leveraged ETFs have been out the decay is very pronounced in commodities and other non-financial assets. However decay is much less pronounced in 'financial' assets like stocks and bonds. I attribute this to the lack of contango in S&P and bond futures. The tracking error doesn't seem to be horrible in the financials. That doesn't mean there can't be an environment where everything falls apart. I don't know what that would look like but I know there were several days in 2008 that the 2X ETF was significantly different than the nonleveraged one for SPY.

I think they achieve leverage in a different way using ULPIX vs SSO and UPRO. I think SSO and UPRO track the underlying index more accurately. Ultimately, it doesn't matter what it does on a daily basis. Rebalance on regular intervals, or use bands, or percent and you harvest the volatility. Think of the decay/volatility as a good thing (presents buying opportunities at a greater discount than the market).

Or be scared and don't do it. Fine by me.

Leverage is bad, you will lose all your savings, go bankrupt, and your spouse will leave you!

DrF

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Re: Indexing with leverage
« Reply #46 on: March 18, 2015, 11:03:54 AM »
And here's a long/short futures strategy of the permanent portfolio. S&P 500, Gold, US 30-yr Bonds and US Dollar futures. Buy if the price is above the 50/200 day moving average (golden cross), sell short if the price is below the 50/200 day moving average (death cross). 1996-2015. There are no stops. Starts with $1 million in equity. https://drive.google.com/file/d/0BzyyTlvGE-T2YlhPblhsdy10aXc/view?usp=sharing

Is this your strategy, or just a strategy?

arebelspy

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Re: Indexing with leverage
« Reply #47 on: March 18, 2015, 11:10:33 AM »

you keep talking about decay, decay is just price weakness that you can take advantage of when you rebalance (quarterly, semi-annual, annual - your preference).

at 10% AA for 3x or 20% AA for 2x, decay doesn't matter.

I think you don't understand what decay is.  You ought to read up a lot more before you implement your strategy.

Good luck, df.
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hodedofome

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Re: Indexing with leverage
« Reply #48 on: March 18, 2015, 11:10:57 AM »
It's just a very simple trend-following system I came up with back in 2012. I don't live trade it as it would require a lot of money for a diversified futures portfolio. I do trade a very similar system using ETFs instead but without leverage.

Just an example of what can be done.
« Last Edit: March 18, 2015, 11:35:16 AM by hodedofome »

DrF

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Re: Indexing with leverage
« Reply #49 on: March 18, 2015, 11:32:43 AM »

you keep talking about decay, decay is just price weakness that you can take advantage of when you rebalance (quarterly, semi-annual, annual - your preference).

at 10% AA for 3x or 20% AA for 2x, decay doesn't matter.

I think you don't understand what decay is.  You ought to read up a lot more before you implement your strategy.

Good luck, df.

Very glib thing to say. I do understand what decay is, and again it doesn't matter when you keep your AA low.