Author Topic: Lowest cost way to achieve leveraged share (index) investment  (Read 1936 times)

s_t

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Lowest cost way to achieve leveraged share (index) investment
« on: November 24, 2018, 05:30:18 PM »
Hi,

Some background for starters:
- Australian
- currently overweight in property, and want to add shares to balance that out. Do have mortgage, but low gearing considering cash sitting in mortgage offset account
- looking to invest in ASX200 or similar Aussie Index (broader OK, preferably not narrower)

So my challenge is to find the overall lowest cost means of buying exposure to the share index. This is for long term investing, not short term trading. Potential solutions include:

1. Take money from the mortgage offset account and buy either shares or an ETF direct. Cost of money to do this is my mortgage rate, at around 4.3%, plus share transaction and/or ETF management fees. This approach is more limited than I would like in terms of keeping/maintaining a healthy cash backup for potential emergencies.

2. Buy shares and/or ETF via a share margin loan. Cost of money about 6.5% at Commsec. Probably cheaper options out there, but always going to be an expensive route to achieve desired exposure.

3. Buy leveraged ETF. No idea on the cost of money the ETF pays (anyone know?). Not recommended long term due to constant re-balancing to maintain exact leverage ratio, which is an artificial constraint of these systems that personally I have no need to maintain.

4. Buy index CFD's via brokers such as Pepperstone or Oanda. Cost of money to do this is their overnight swap rates - they typically charge 2.5% over actual rates - which means a cost of about 4.5% pa currently. They pay out amounts equivalent to the dividends, but you loose the franking credit. Very high leverage useful as leaves almost all cash available in offset account as safety buffer for general life (and investment performance...).

5. Buy LEPO (options) in the ASX200 (XJO). Cost of money should theoretically be close to Bank Bill Swap Rates, currently just below 2%. Roll-over costs (slippage, commissions etc) several times a year. I haven't looked into it, but doubt franking credits associated with dividends are considered when calculating value of options.

6. Sell in the money puts (XJO). Cost of money should theoretically be close to Bank Bill Swap Rates, currently just below 2%. Roll-over costs (slippage, commissions etc) several times a year. Added benefit in that you receive cash/premium for taking on volatility/risk, but you loose/miss out on further gains should the index rise beyond strike price.

7. Buy SPI200 futures contracts. Cost of money should theoretically be close to Bank Bill Swap Rates, currently just below 2%. Roll-over costs (slippage, commissions etc) several times a year. I haven't checked, but doubt franking credits associated with dividends are considered when calculating value of futures contract. With the proliferation of CFD, seems less brokers actually do this nowadays.

Are there any major alternatives that I have not mentioned above? Does anyone have any comments or more detailed information on which is the lowest costs?

I suspect my most cost efficient way of doing this is actually number 7, buying SPI200 futures. Seems that CFD's are easy, but they are further removed from the core underlyings and you are paying for that convenience and packaging.

Before people raise it, I am very aware of the risks of leverage, and I do ensure my total portfolio/asset leverage rates are at acceptable levels, and that cash can be moved around to ensure drawdowns in particular assets/instruments can be covered.

I have been doing number 6 (selling in the money puts) for some time, which has worked out well, but of the above possibilities is least likely to replicate the index and is at high risk of missing big moves up. I do have some index exposure through CFD's (option 4), which the brokerage industry has now set-up in such a way as to make it very easy and cheap commission wise, but long term the overnight swap/funding rates will eat into performance.

Appreciate any suggestions on the lowest cost way for me to gain that ASX200 exposure.
« Last Edit: November 24, 2018, 06:00:00 PM by s_t »

jacoavluha

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #1 on: November 24, 2018, 06:42:39 PM »
I don’t understand most of what you wrote. I would say I would not incur debt in order to invest. And I wouldn’t do options, futures, puts, whatever.

So you do have cash you can invest? Or not?

s_t

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #2 on: November 24, 2018, 07:28:33 PM »
I don’t understand most of what you wrote.

I may be using some Australian specific terminology, which would make it harder. But a good understanding of the different financial instruments raised would be necessary to understand the post. And I may not be writing clearly...

I would say I would not incur debt in order to invest. And I wouldn’t do options, futures, puts, whatever.

So you do have cash you can invest? Or not?

What, you buy property/house/shares with cash only - no debt allowed? That's fine, but I choose to take a more aggressive investment approach than that.

Yes I have cash in an offset account (kind of like a re-draw account), that is currently reducing the interest I pay on property mortgage. I could use that cash to buy shares/ETF (option 1 in my list in original post), but it may not be the most cost efficient way of getting the exposure I'm after, and has disadvantages in tying up emergency cash reserves.

jacoavluha

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #3 on: November 24, 2018, 08:10:29 PM »
No problem with a mortgage. Real estate investing is beyond my expertise/interest. But you’re basically talking about debt to invest in equities. Or options. Or whatever. I wouldn’t do that.

s_t

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #4 on: November 26, 2018, 02:24:32 AM »
The below link provides a very good approach on 'investing order' for Australians.

https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333550/#msg1333550

I have done all of steps 1-6, and have a large amount of cash sitting in an offset account. The next step is investing in equities (step 7).

All I am looking at is the most cost efficient way of doing that. Taking the cash out of the offset account/redraw/mortgage/bank account and using to buy shares/ETF (as suggested in above link) may not be the most cost efficient in terms of borrowing costs. It is what a huge number of people do though - anyone who buys shares when they haven't fully paid off their house/property is doing exactly this. Using what is effectively borrowed money that could be used to pay off the mortgage instead.

Whilst property finance is relatively low cost and a very common method of freeing up capital, and certainly better than share margin loans, it seems there are cheaper options (such as futures contracts, options etc).

Seems everyone is happy to pay the bank and enrich their shareholders pockets, without even consider the cost of alternative sources of funding (which is what buying a futures contact is effectively - an alternative source of loan/funds for buying exposure to shares/indices).

Notch

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #5 on: November 26, 2018, 03:44:11 AM »
I don't know enough about options to give any advice there, but just wanted to remind you that since margin loan interest is tax-deductible, the relevant interest rate is = interest rate * (1 - marginal tax rate), eg. 6.63% * (1-0.39) = 4.04%

mrmoonymartian

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #6 on: November 26, 2018, 04:01:09 AM »
Thanks for the list. Sorry, no more alternatives to add as you know more than I do about this stuff. I've been paying off my house before investing outside super.

Being in a similar mortgage situation, I've tried but really can't see the case for Aussies to take money out of the offset to invest in stocks if you're still working and paying tax. That money in the offset account is giving guaranteed tax-free returns. See the WHY section for points 2 and 3 in that investment order link you gave.

Maybe you will argue that with leverage the taxed return is still greater than the tax-free mortgage interest return, on average. Maybe you'd be right. But that's just the average. What about the black swans? I don't know how to calculate risk-adjusted returns to do a more meaningful comparison, but if I'm under 10 years from having enough anyway it doesn't seem like a good idea for me. Maybe if you're younger and need to FIRE to a HCOLA it could be worth all that extra stress and hassle??


ETA: I think you missed the key word in the investment order point 7, which is 'extra'. That is, you're still at point 3 and don't have any 'extra' yet.
« Last Edit: November 26, 2018, 04:19:39 AM by mrmoonymartian »

s_t

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #7 on: November 26, 2018, 05:19:46 AM »
I don't know enough about options to give any advice there, but just wanted to remind you that since margin loan interest is tax-deductible, the relevant interest rate is = interest rate * (1 - marginal tax rate), eg. 6.63% * (1-0.39) = 4.04%

Thanks Notch, good point.

Thanks for the list. Sorry, no more alternatives to add as you know more than I do about this stuff. I've been paying off my house before investing outside super.

Being in a similar mortgage situation, I've tried but really can't see the case for Aussies to take money out of the offset to invest in stocks if you're still working and paying tax. That money in the offset account is giving guaranteed tax-free returns. See the WHY section for points 2 and 3 in that investment order link you gave.

Maybe you will argue that with leverage the taxed return is still greater than the tax-free mortgage interest return, on average. Maybe you'd be right. But that's just the average. What about the black swans? I don't know how to calculate risk-adjusted returns to do a more meaningful comparison, but if I'm under 10 years from having enough anyway it doesn't seem like a good idea for me. Maybe if you're younger and need to FIRE to a HCOLA it could be worth all that extra stress and hassle??


ETA: I think you missed the key word in the investment order point 7, which is 'extra'. That is, you're still at point 3 and don't have any 'extra' yet.

Thanks. If we take the baseline as literally sticking cash in the mattress, then yes, putting it in an offset account gives me 4.3% extra tax free.

But what if we stick say 80% of it in the offset account, giving 3.44% return tax free. The remaining 20% I use to get share/indice exposure by buying ASX200 CFD, or SPI200 futures, or ASX200 options. To the same exposure/value as 100% of the cash that would have been in the mattress.

If I were to do via CFD, the interest/swap costs are about 4.5% which should be roughly what they also pay out in adjustments to account for dividends (not sure exactly what the dividend yield on ASX200 is?). So I'd just be exposed to price movement only - asx200 changes by x% and I make an 3.44% + x% less tax on x% (if x is positive).

In futures, the interest rate and the dividend allowances are incorporated/calculated in the traded price. But it seems the combination of adjustment for interest and dividends is a positive allowance (as evidenced by further out contracts being priced more cheaply than close ones). Assuming it is positive 2% pa equivalent, then the return is 3.44% + x% + 2% less tax on x+2% (x being % asx change again). In short you get most of the benefits of your offset account, you get paid to hold the ASX200 (as cost of capital is less than dividend rate), and you get the capital gains (that will occur over the long term, not necessarily in the short term). It should be noted that if the ASX200 falls significantly you may have to pull some money out of the offset to fund margin requirements for the futures contract.

I haven't actually done this with futures yet, hence these posts for comment, but it seems to be the lowest cost finance available.

bigchrisb

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #8 on: November 26, 2018, 05:23:02 AM »
Don't assume that margin loans are necessarily more expensive. My current interest only margin loan ($450k) worth is similarly priced to my mortgage (4.15% v 4.01%). In both cases, it's well worth negotiating with your lender (in my case a big 4 bank for the margin loan and rmbs shadow back for the mortgage).

Also, have you considered splitting your loan, paying out the split fully and doing a new draw down for the investment portion? Keeps the accounting and tax status clearer.  Certainly wouldn't use the offset.

s_t

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #9 on: November 26, 2018, 05:28:33 AM »
Also, have you considered splitting your loan, paying out the split fully and doing a new draw down for the investment portion? Keeps the accounting and tax status clearer.  Certainly wouldn't use the offset.

No I hadn't. Will look into that. Thanks.

jacoavluha

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #10 on: November 26, 2018, 06:34:21 AM »
Again, I would not invest in equities with money I don’t have. I guess we don’t have “offset accounts” here in the US. Or I’m just unfamiliar because I don’t do real estate investing. But if it’s not fully available cash, I wouldn’t invest it. Seems to me any way you slice it, you’re taking about additional debt.

mrmoonymartian

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #11 on: November 26, 2018, 07:35:39 AM »
I don't know enough about options to give any advice there, but just wanted to remind you that since margin loan interest is tax-deductible, the relevant interest rate is = interest rate * (1 - marginal tax rate), eg. 6.63% * (1-0.39) = 4.04%

Thanks Notch, good point.

Thanks for the list. Sorry, no more alternatives to add as you know more than I do about this stuff. I've been paying off my house before investing outside super.

Being in a similar mortgage situation, I've tried but really can't see the case for Aussies to take money out of the offset to invest in stocks if you're still working and paying tax. That money in the offset account is giving guaranteed tax-free returns. See the WHY section for points 2 and 3 in that investment order link you gave.

Maybe you will argue that with leverage the taxed return is still greater than the tax-free mortgage interest return, on average. Maybe you'd be right. But that's just the average. What about the black swans? I don't know how to calculate risk-adjusted returns to do a more meaningful comparison, but if I'm under 10 years from having enough anyway it doesn't seem like a good idea for me. Maybe if you're younger and need to FIRE to a HCOLA it could be worth all that extra stress and hassle??


ETA: I think you missed the key word in the investment order point 7, which is 'extra'. That is, you're still at point 3 and don't have any 'extra' yet.

Thanks. If we take the baseline as literally sticking cash in the mattress, then yes, putting it in an offset account gives me 4.3% extra tax free.

But what if we stick say 80% of it in the offset account, giving 3.44% return tax free. The remaining 20% I use to get share/indice exposure by buying ASX200 CFD, or SPI200 futures, or ASX200 options. To the same exposure/value as 100% of the cash that would have been in the mattress.

If I were to do via CFD, the interest/swap costs are about 4.5% which should be roughly what they also pay out in adjustments to account for dividends (not sure exactly what the dividend yield on ASX200 is?). So I'd just be exposed to price movement only - asx200 changes by x% and I make an 3.44% + x% less tax on x% (if x is positive).

In futures, the interest rate and the dividend allowances are incorporated/calculated in the traded price. But it seems the combination of adjustment for interest and dividends is a positive allowance (as evidenced by further out contracts being priced more cheaply than close ones). Assuming it is positive 2% pa equivalent, then the return is 3.44% + x% + 2% less tax on x+2% (x being % asx change again). In short you get most of the benefits of your offset account, you get paid to hold the ASX200 (as cost of capital is less than dividend rate), and you get the capital gains (that will occur over the long term, not necessarily in the short term). It should be noted that if the ASX200 falls significantly you may have to pull some money out of the offset to fund margin requirements for the futures contract.

I haven't actually done this with futures yet, hence these posts for comment, but it seems to be the lowest cost finance available.
Thanks for the breakdown. Food for thought!

I found this thread which has a brief but insightful discussion including mention of the strategy you're talking about (holding cash to cover a 100% drawdown). https://futures.io/emini-index-futures-trading/33470-buy-hold-tell-me-why-i-m-wrong.html

s_t

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #12 on: December 02, 2018, 02:02:40 AM »
The below is a really interesting thread that highlights:
- futures on indices are the cheapest form of credit and leverage (ignoring the 0% cc offers!!!)
- the risks of using too much leverage
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=5934

and another interesting one from bogleheads that I've started reading:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=143037

Futures and options may not be so good in terms of capital gains tax though. They require regular roll-over which means crystallising gains/losses; ie. they are taxable events. With direct shares, ETF's and CFD's you can choose to hold them long term and delay the taxable event (and hence tax paid to tax office) accordingly.

The 50% capital gains discount on assets held more than a year is a factor to consider. Futures and options contracts do go out past a year, but all the volume is in the nearest contract so I don't yet know what impact going out over a year has on execution.

s_t

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Re: Lowest cost way to achieve leveraged share (index) investment
« Reply #13 on: December 19, 2018, 04:26:42 AM »
Just rolled over a deep in the money written put on ASX200 (XJO), Dec to March, and received just shy of 1% for the 3 months (3.8% pa ). Very little time value as deep in the money, so most of that must be dividend yield, less [an apparently very small] interest cost.

This is point number 6 in my original post, which I've been doing with one contract for 1.5 years now.

Very difficult to know what the pricing/rollover should be without actual dividend info though. Anyone know where I can look up expected/announced/forecast dividend payouts for the ASX200 over specific timeframes (eg. 20 Dec 2018 to 21 Mar 2019)?

Dividend info becomes even more important if I want to write over a year out for capital gains tax discount reasons.