Author Topic: trinity study, SWR, and how leverage apparently screws you  (Read 2585 times)

aajack

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trinity study, SWR, and how leverage apparently screws you
« on: March 16, 2018, 05:41:59 PM »
Hey guys! Ok i've spent this beautiful Friday afternoon nerding out in Excel... I really need to learn how to code! I have been curious as to how a leveraged portfolio (such as UPRO, TQQQ, or UDOW) would alter your SWR. Since these funds don't go back very far, I took S&P data from 1950, got the daily % change, multiplied by 3 and let that represent a 3X portfolio from 1950. I then tested different withdrawal rates for 30 year periods - 1950-1980, 1951-1981, etc. Here are my results.

What do you guys think? I don't think I'm too surprised - leverage makes the good times better and the bad times worse. I am curious if other lesser degrees of leverage would have been better - maybe like 1.5 times. Also curious if you're better off if you leverage while you're still working and contributing money, and then switch over to 1x the market when you're ready to retire and start taking withdrawals. Thoughts? Has anyone else tried something similar?

I think this is a really interesting topic. Another thing I'm curious about is CEF's that pay supposedly stable ~8% distributions - but leverage at 1.3-1.4x. I wonder how stable those actually are. 

« Last Edit: March 16, 2018, 05:45:53 PM by aajack »

aajack

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #1 on: March 16, 2018, 05:49:02 PM »
I should clarify that the Excel chart I made, and the other is just a regular old S&P chart... I wanted to see what the market was doing at the time period where the 3X leverage was the lowest (at 2.6%). Not surprisingly, the periods with those low SWR's were initiated by big market crashes.

maizeman

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #2 on: March 16, 2018, 06:50:12 PM »
Yup, this makes sense but it's interesting to see the chart.

One thing that probably should factor into this comparison is the interest costs of carrying all that leverage. Looking at the three funds you mentioned, their expense ratios are all >0.95%. Vanguard's S&P 500 index is at about 0.05, so let's say the carrying cost of the leverage is .9% annually. That's only 0.0025% daily, but I bet if you subtracted that from every one of your 3x daily returns, the results would look notably worse.

ILikeDividends

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #3 on: March 16, 2018, 07:08:16 PM »
You should read the disclosure for leveraged products.  Here's the salient info for UPRO:

"Risks of Leveraged & Inverse Products

Leveraged ETPs (Exchanged Traded Products, such a ETFs and ETNs), seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETPs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding and possible correlation errors, leveraged and inverse products may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETP and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETPs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, options, can increase ETP volatility and decrease performance. Investors holding these ETPs should therefore monitor their positions as frequently as daily. To find out more about trading Leveraged and Inverse Products, please read Leveraged and Inverse Products: What you need to know."

Basically, taking a long position in these products is for extremely short duration hedges; think market makers, day traders, maybe swing traders (emphasis on "maybe").  Extrapolating long term results from an S&P 1x index fund over a period of years is kind of like comparing apples to hammers.  You just can't accurately model all the moving parts involved in a leveraged product; regardless of whether you're using Excel or Mathematica.
« Last Edit: March 16, 2018, 07:38:31 PM by ILikeDividends »

Toad

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #4 on: March 16, 2018, 09:54:10 PM »
I think it is a bit exaggerated how rapidly leveraged funds will get out of whack from the underlying unleveraged.  That being said, I would never myself hold a leveraged ETF overnight unless I was hedged against it in some way...but I would say swing trading with these is not completely absurd.  But, when we start talking about investing instead of trading...yes...the use of these to leverage your position falls under the very bad idea category in my opinion.  I have attached a % change graph for SPY and SPXL (basically same as UPRO...3x leveraged S&P) for a two year period.  You can pretty clearly see that the SPXL is way out of whack (about 30% off!!) of where it would be if it simply worked as 3x S&P 500 after only two years which is nothing in investing terms.

A much better way to leverage your position (in my opinion) would be to simply use margin with your broker and just take twice the position size (or anything between 1x and 2x).  Of course just about every broker has an absurd fee for margin...every broker except Interactive Brokers which has their rate at about 3%...probably reduces some as the amount of margin you use increases.  More typically you will see 8%+ rates to go on margin (this is what my brokerage accounts have) negating any benefits if just doing a long term whole market hold type approach.  That said...I wouldn't even touch going 2x margin...probably the most I would consider doing if I did something like this would be around 1.25x.

The thing people don't seem to consider when thinking about leverage is by using it there is a very real, non-zero chance your account blows up.  I think most would agree that a 100% drop in the market is an impossibility, but a 75% drop is a very real possibility...a 50% drop even more so.  At 1.25x leverage you would be looking at a 80% drop that would wipe your account out...I would probably take those odds with some safeguards built in to remove margin at a certain point.

At 1.5x margin you are looking at a 66% drop that would wipe your account out and at 2x margin a 50% drop wipes you out.  I wouldn't tread those waters without having very strict protocols in place for when to reduce margin, but even then it seems foolish to me.

Edit to add:
I would suspect you would receive a margin call before your portion reached zero though, so probably even less of the drops I noted to blow up your account.
« Last Edit: March 16, 2018, 09:59:22 PM by Toad »

bacchi

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #5 on: March 16, 2018, 11:18:30 PM »
Edit to add:
I would suspect you would receive a margin call before your portion reached zero though, so probably even less of the drops I noted to blow up your account.

If you ever get a margin call from IB in a serious market decline, it's almost too late. Even a wire won't be fast enough before they start liquidation.

They'll also raise margin requirements at a moments notice. It's how I lost 90% in 2008.

SeattleCPA

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #6 on: March 17, 2018, 07:13:07 AM »
Do you know that you can model a leveraged portfolio with cFIREsim and FIRECalc?

The trick: You enter the bonds percentage as a negative value.

I provided step by step instructions in a blog post last summer:

Portfolio Leverage Modeling with cFIREsim and FIRECalc


Rob_bob

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #7 on: March 17, 2018, 02:32:44 PM »
Hey guys! Ok i've spent this beautiful Friday afternoon nerding out in Excel... I really need to learn how to code! I have been curious as to how a leveraged portfolio (such as UPRO, TQQQ, or UDOW) would alter your SWR. Since these funds don't go back very far, I took S&P data from 1950, got the daily % change, multiplied by 3 and let that represent a 3X portfolio from 1950. I then tested different withdrawal rates for 30 year periods - 1950-1980, 1951-1981, etc. Here are my results.

What do you guys think? I don't think I'm too surprised - leverage makes the good times better and the bad times worse. I am curious if other lesser degrees of leverage would have been better - maybe like 1.5 times. Also curious if you're better off if you leverage while you're still working and contributing money, and then switch over to 1x the market when you're ready to retire and start taking withdrawals. Thoughts? Has anyone else tried something similar?

I think this is a really interesting topic. Another thing I'm curious about is CEF's that pay supposedly stable ~8% distributions - but leverage at 1.3-1.4x. I wonder how stable those actually are.

I've heard how it works several times and still don't really get it but as pointed out by ILikeDividends above, the leverage and % resets daily on these leveraged ETN and ETF so they are very short term trades.

Now as to CEF's they use leverage more along the lines of a margin account or even borrowing money to buy real estate and it work for long term.  The leverage will cause the NAV to fluctuate more.  As to how stable the distributions are that all depends on the fund management.  Some funds payed steady distributions through 2008 and 2009 even though their share prices tanked.  Some funds recovered their NAV after 2008, others didn't.  Some funds grow their NAV over time, others erode their NAV by paying it out to cover some portion of the distribution, kind of like retired people who spend down their assets hoping that the check to the funeral hope zeros out their account balance  :)

ChpBstrd

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #8 on: March 17, 2018, 08:55:12 PM »
Here's an epic, epic, and epic thread on the topic:

https://www.bogleheads.org/forum/viewtopic.php?t=5934

Also, if you want to leverage, buy LEAP call options on SPY. The cost to control SPY shares until December 2020 is about 10% of the cost of the shares ($275 call is ~$27.50/share). So you could replace your whole portfolio with these options representing the number of shares you would otherwise have owned. Then put the remaining 90% in fairly safe short-term bonds earning around 2% (replacing the current dividend on SPY). You would underperform the index or fund by just over 10% in this scenario BUT your portfolio's maximum loss would be capped at the value of the calls - 10% (and that only if SPY is equal to or lower in 2.75 years than it is today and the call options expire worthless - a relatively improbable scenario, historically speaking).

You could, of course, decide to risk more of your portfolio. For example, buy twice as many calls for double leverage. Your max loss becomes roughly 20% and your max gain becomes 200%-20% of the performance of SPY. But the idea would be reducing risk by capping your downside while simultaneously obtaining a leveraged upside. Isn't that what we'd all like?

BTDretire

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #9 on: March 18, 2018, 07:16:05 AM »
I want to reiterate what ILIKEDIVIDENDS highlighted in his post.
Those 3x funds reset daily so I don't know that your excel maths works.
I lost momey using one, because I didn't understand it, I still don't.

That said, your chart would look even better if you only spent say 6%
in the good times and reinvested the rest for those down times.

maizeman

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #10 on: March 18, 2018, 08:33:21 AM »
I took S&P data from 1950, got the daily % change, multiplied by 3 and let that represent a 3X portfolio from 1950. I then tested different withdrawal rates for 30 year periods - 1950-1980, 1951-1981, etc. Here are my results.

I want to reiterate what ILIKEDIVIDENDS highlighted in his post.
Those 3x funds reset daily so I don't know that your excel maths works.

Since aajack is using the daily % change, their results should indeed be correct (aside from the difference in expense ratios between regular funds and leveraged funds).

Essentially the issue with daily leveraged funds is the same reason "averaging" return isn't an informative number and we have to use CAGR instead.

Imagine the stock market goes up 10%, down 30% and up 20%.

The average return is zero (10%-30%+20%)/3.

$100 invested in a stock market index becomes $100->$110->$77->$92.4 for an overall loss of 7.6%.

$100 invested in a 3x leveraged fund becomes $100->$130->$13->$20.8 for an overall loss of 79.2%

So in this particular example the 3x leveraged ends up with more than 10x the losses of the unleveraged underlying index.

ILikeDividends

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #11 on: March 19, 2018, 02:59:44 PM »
I took S&P data from 1950, got the daily % change, multiplied by 3 and let that represent a 3X portfolio from 1950. I then tested different withdrawal rates for 30 year periods - 1950-1980, 1951-1981, etc. Here are my results.

I want to reiterate what ILIKEDIVIDENDS highlighted in his post.
Those 3x funds reset daily so I don't know that your excel maths works.

Since aajack is using the daily % change, their results should indeed be correct (aside from the difference in expense ratios between regular funds and leveraged funds).

Essentially the issue with daily leveraged funds is the same reason "averaging" return isn't an informative number and we have to use CAGR instead.

Imagine the stock market goes up 10%, down 30% and up 20%.

The average return is zero (10%-30%+20%)/3.

$100 invested in a stock market index becomes $100->$110->$77->$92.4 for an overall loss of 7.6%.

$100 invested in a 3x leveraged fund becomes $100->$130->$13->$20.8 for an overall loss of 79.2%

So in this particular example the 3x leveraged ends up with more than 10x the losses of the unleveraged underlying index.
This is a very illustrative example in a general sense.  However, it doesn't capture the scenario where the ETP provider changes the leverage ratio, out of the blue.  In February, UVXY was changed from a 2x leveraged product to a 1.5x leverage product pretty much without warning for any but the shortest of duration traders.  If you held a long position a few days before that event, tough cookies.  You now own a different product than what you bought.  You don't get a refund for the dilution in that event.

The very real risk of such an event simply can't be modeled in a meaningful way. 
« Last Edit: March 19, 2018, 11:51:43 PM by ILikeDividends »

bwall

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #12 on: March 19, 2018, 10:52:39 PM »
Leverage can cause a lot of damage.

If you have a free afternoon and want an entertaining read, go over to bogleheads and check out Marketimer's "Mortgage your Retirement" Thread.

https://www.bogleheads.org/forum/viewtopic.php?f=10&t=5934

Thanks to L.A.S. and ChpBstrd for the link to the epic post. What a classic read! OMG! I spent two full days reading the slow motion train wreck. It reminded me of another one that I read years back, on a classic car forum.

Is there a good place to share epic forum posts? If anyone has about two days and wants to ready another real (forum) life soap opera drama, then please be my guest. Subject matter: Fraudulent classic Porsche worth about a quarter million and a story Hollywood would pay a million for:

http://forums.pelicanparts.com/porsche-911-technical-forum/365081-73-rs-fraud-must-read.html

gerardc

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #13 on: March 19, 2018, 11:43:31 PM »
I took S&P data from 1950, got the daily % change, multiplied by 3 and let that represent a 3X portfolio from 1950. I then tested different withdrawal rates for 30 year periods - 1950-1980, 1951-1981, etc. Here are my results.

I want to reiterate what ILIKEDIVIDENDS highlighted in his post.
Those 3x funds reset daily so I don't know that your excel maths works.

Since aajack is using the daily % change, their results should indeed be correct (aside from the difference in expense ratios between regular funds and leveraged funds).

Essentially the issue with daily leveraged funds is the same reason "averaging" return isn't an informative number and we have to use CAGR instead.

Imagine the stock market goes up 10%, down 30% and up 20%.

The average return is zero (10%-30%+20%)/3.

$100 invested in a stock market index becomes $100->$110->$77->$92.4 for an overall loss of 7.6%.

$100 invested in a 3x leveraged fund becomes $100->$130->$13->$20.8 for an overall loss of 79.2%

So in this particular example the 3x leveraged ends up with more than 10x the losses of the unleveraged underlying index.

Yep. An easy way to understand why those reset-daily leveraged ETFs suffer from drag if you hold them long term is to imagine that the tracked index is essentially doing a random walk (daily noise) around a slight upwards trend, as does the S&P. The problem is that whenever that noise is up, you'll effectively buy more shares the next day (because your new market value is still 3X leveraged by the ETF); when the index is down, you'll buy less shares. Over time, you tend to buy high and sell low, thus the drag.

The way to defeat this drag is to increase your reset horizon, i.e. reset at a lower frequency than daily, e.g. yearly. To do this you can buy term leveraged shares, or leverage yourself in a brokerage account with a base investment that is fixed over the entire duration of the term. If you do this, there is a margin call risk, but there is no drag. Compared to a reset-daily ETF, you are effectively doubling down when the index is down, and easing up when it is high.

I haven't seen this published elsewhere, but there is a way to simulate term leverage or DYI leverage using only daily ETFs. To do this, you need to actively buy/sell at the start of each trading day so that your invested base remains constant. Example with a 3X ETF:

You start with a $100 investment. Under the hood, the ETF invests $300 on your behalf. You need to keep that $300 market gains constant, as if you had a DYI leverage in a brokerage.
Day 1
  start: index value=100, ETF value=100, under the hood invested assets=300
  end: index value=101, ETF value=103, under the hood invested assets=303 (not reset yet)
Day 2
If you hold:
  start: index value=101, ETF value=103, under the hood invested assets=309 (too much!)
Under the hood investment must stay at 303, so you must sell $2 of your ETF to get:
  start: index value=101, ETF value=101, under the hood invested assets=303 (just right!)

In other words, make sure that at the start of each day you have the same amount in your ETF as you would have had if it was invested in the index! Then, you'll suffer no drag.

Of course, to do this you need another account (which could be invested in the index) to use to buy more when the 3X ETF goes down, and sell into when the ETF goes up. This acts as your margin account. You can't 3X leverage 100% of your portfolio. Further, the smaller this "margin" account (that you manage), the higher the chance of a "margin call" to yourself where you'll be unable to double down on the ETF when its value drops too much, but no one will force you to liquidate the account, you'll just suffer (a lot of) drag.

Mind doing your simulation again so we can see how this method works out in practice? Long-term performance of daily-reset ETFs is expected to be poor.

Toad

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Re: trinity study, SWR, and how leverage apparently screws you
« Reply #14 on: March 20, 2018, 01:09:01 AM »
Example with a 3X ETF:

You start with a $100 investment. Under the hood, the ETF invests $300 on your behalf. You need to keep that $300 market gains constant, as if you had a DYI leverage in a brokerage.
Day 1
  start: index value=100, ETF value=100, under the hood invested assets=300
  end: index value=101, ETF value=103, under the hood invested assets=303 (not reset yet)
Day 2
If you hold:
  start: index value=101, ETF value=103, under the hood invested assets=309 (too much!)
Under the hood investment must stay at 303, so you must sell $2 of your ETF to get:
  start: index value=101, ETF value=101, under the hood invested assets=303 (just right!)

In other words, make sure that at the start of each day you have the same amount in your ETF as you would have had if it was invested in the index! Then, you'll suffer no drag.

Keep in mind though that the "reset" would actually be pre-market, not market open.  Similarly, the end of day would be post-market not simply market close...this further convolutes an already convoluted idea...ever tried buying or selling pre- or post- market when the market is rapidly moving?...Very frustrating since you will end up chasing the price in many cases.