Lifecycle Investing and Leverage -Alternative Strategies

[tripleoptician]

http://islandia.law.yale.edu/ayres/Life-Cycle%20Investing%20Working%20Paper.pdf

 

This Yale paper above has left me reviewing my thoughts on leverage and its benefits/drawbacks. The synopsis shows establishing 2:1 leverage when young with deleveraging over time results in 90% more wealth than standard lifecycle investing (110 minus your age for equity exposure) and 19% higher than a perpetual 100% stock portfolio. This is based on data from 1871 and seems to hold up to rigorous analysis.

My initial thoughts are using derivatives and margin to gain increased exposure as suggested leaves significant vulnerability to blow up unnecessarily with callable debt. I think this was covered in an old thread well also "LEAPS, margin and higher returns"

 

As a youngish investor, I've looked for alternatives and it seems their are multiple ways of pursuing leverage that may not get up to 2:1, but can establish greater than 100% exposure with far less risk.  I'm curious if anyone else has employed the following to establish greater than 100% exposure without using options:

 

1) Utilizing a home equity line of credit as your mortgage is paid down. This is effectively non-callable debt and relatively secure principal (your home). In Canada we get the added benefit of converting non-tax deductible mortgage debt into taxable (Smith Manouevre) This unfortunately will often be small sums when younger and larger near the end of the mortgage amoritization but still allows quicker growth of total investable assets.

 

2) Applying for investment loan with pledged collateral:

I've found out about two types so far (first I have done and second is proposed)

 

a) long-dated term loan of 25 years at prime + 1% interest where established long term holdings were submitted as collateral and 2x was given in loan amount with all assets being collateral for the bank (ie. $250 K in assets led to $500 K loan to invest with $750 K in total collateral). Benefits of this were margins were tested at 1 year and then never again. Downside was the holdings could only be sold down if the same L:V ratio was maintained. This would work well with established owner-operators that are long term holds.

 

b) shorter amoritization loan of 6-7 years with ~50% loan to total investable assets ($400 K pledged for $200 K loan) at prime interest with margins tested 1x/year with a requirement to return to the same L:V within 6 months after margin tested. This leaves a longer timeframe than immediate margin call but bears more risk than the above. The benefit is slightly cheaper leverage and total freedom to buy/sell within various securities as long as funds aren't withdrawn from investment account.

 

c) unsecured LOC's - This may be something I'm able to get due to higher income earning capacity/good credit, but this seems like the most ideal leverage overall. I was able to establish a basic professional LOC unsecured and now a ~15% of total net worth LOC that has no risk of being called at any time and at a competitive rate (prime).

 

Does anyone else use any of the above? Are there any other forms of non-callable leverage that people know of?

I should qualify this is more a general strategy concern and not a comment on this specific market timing for leverage.

 

Thanks in advance!

 

 

 

 

[DoddDisciple]

I'd be interested in this too. The most common/easiest type of leverage to get for stocks is margin, but looking at what can happen there, I'd be scared to fool with it. I've read about people getting their positions liquidated on IB even though they have enough cash to cover the increased maintenance. Additionally, I don't think stocks below $250M market cap are marginable, and that's what I'm interested in.

 

How is the paperwork right now for a home equity line of credit? I did a FHA first time homebuyers loan and had more than enough in cash to pay for the house outright sitting in the bank and it was still a huge pain in the ass.

[CorpRaider]

I think there's a thread on bogleheads where a young finance phd tried to implement this strategem and went kaboom, as you suggest.  I could see cashing out via a refi, I was actually toying with this idea when rates were @ 3.375 for 30 years.  I've also sort of looked around to little avail for a good S&P 500 clone (would be even better with a value tilt) closed end fund with about 30% leverage as a way to get the leverage which wouldn't be recourse to me and also wouldn't have the obvious structural flaws of the levered ETFS.  Of course I'm not remotely thinking about buying them after a five year raging bull.

[DoddDisciple]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

[tripleoptician]

TTTdodder

 

HELOC paperwork in Canada seems pretty straightforward. I think you always need to maintain 20% equity in the home and can borrow over that to a maximum of 80% of total mortgage value. I'm sure your credit score etc will affect the ease of opening a HELOC.

 

Another point is I think the essay doesn't include the tax deductible benefit which can significantly alter your interest hurdle rate required for your investment selections.

 

[CorpRaider]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

 

The ETFs are structurally flawed, in that they have to unwind the leverage daily.  I think there's a thread on here discussing their problems and higlighting them as a short opportunity.  CEF's usually just issue preferred stock for their leverage and obviously aren't redeemable and don't settle up daily.

[Hielko]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

 

The ETFs are structurally flawed, in that they have to unwind the leverage daily.  I think there's a thread on here discussing their problems and higlighting them as a short opportunity.  CEF's usually just issue preferred stock for their leverage and obviously aren't redeemable and don't settle up daily.

I don't think daily rebalancing is a problem (except for the trading costs). Sure, volatility in returns is going to affect your final performance because of how compounding works, but it doesn't make money disappear.

[Guest wellmont]

so many threads about increasing investment leverage 5 years into a massive bull market. mostly from the youngsters who I think want to get "there" quickly. the time to put on leverage was in 2009. I would review what Buffett has to say about using leverage. I used to know a very rich guy who thought it was odd that people borrowed money to buy their cars.

 

 

[frommi]

so many threads about increasing investment leverage 5 years into a massive bull market. mostly from the youngsters who I think want to get "there" quickly. the time to put on leverage was in 2009. I would review what Buffett has to say about using leverage. I used to know a very rich guy who thought it was odd that people borrowed money to buy their cars.

 

I thought the same, must be the final phase of the bullrun.  ;D

[ERICOPOLY]

I had a mortgage that gave me the option of prepaying an amount of mortgage principle every month.  I believe that is very common and almost everyone with a mortgage has this option.

 

So whenever they instead decide to put it into equities, they are using leverage.  The alternative was to pre-pay the mortgage.  Instead, they purchase equities.

 

Seems pretty straightforward.  Their choice to purchase equities leaves them with more debt.

[watsa_is_a_randian_hero]

I've seen this same research.  The CFA program in level 3 also talks about the need to view one's portfolio including "human capital."  I would define "human capital" as your ability to generate earnings beyond your needs (ie, ability to generate savings), discounted to present value.  To the extent you are young, smart, and have a career in a lucrative field, you will have a high degree of human capital.

 

I don't think this is a bad idea in general, but the timing of choosing to implement 5 years into a bull market is not the best.  I was fortunate and happened to graduate in 2007 with a job that paid well enough for me to afford saving at least half my after-tax income each year.  I was levered in 08/09/10, and again after the US debt downgrade in 11, but have delevered since then. 

 

I still have a margin balance in my taxable account, but have high amounts of cash in my IRAs and also S&P 500 futures shorts.  Net-net my average beta across my portfolio now is 0.7, which includes a beta estimate on non-stock fixed-income (FFH bonds, JCP bonds, 30-year treasury short, Lending club account) and reit investments I've taken.  Looking at just the stocks I own, I'm long in 85% of my NW with a beta of 0.92, offset by short 22% short S&P 500.

 

Bottom line: I'd advise you to use leverage carefully, consider the market level, and also consider how much money you can save in a year.  When I was levered in 08/09/10, I was at the beginning of my career, and because my portfolio starting out was small relative to the savings each year, the amount borrowed could have been paid off with savings within a year if needed.  This provided a degree of protection from margin calls, because I was continuously adding deposits from paychecks. 

[tripleoptician]

Hi Watsa

 

I agree strongly with your post. I also levered in 2009 and again in 2011 mainly because my cash flow was very strong, I was just starting investing and I liked the general market opportunities.

I obviously agree now isn't the time to employ significant leverage. I have gone from notional 130% to about 90% currently.

What I'm debating is if there is a point in maintaining a cash cushion for market opportunities at all. I understand the need for managers to he cash cushions for dry powder and redemption purposes, but I don't have that worry as an individual investor. If the market took a 30-50% decline and I was fully invested, I would use non recourse debt to get up to 150% notional. I'm currently establishing as much unsecured LOC loan freedom as possible to ensure I can put it to work when the market creates favorable terms.

It was near impossible to get favorable loan terms in a timely fashion during the financial crises as credit had dried up. Therefore thinking about this strategy now will allow us to be opportunistic when the next downturn presents itself.

[watsa_is_a_randian_hero]

Tripleoptician:

 

My thoughts on portfolio leverage I shared earlier was for engaging in a leverage strategy through standard brokerage tools: margin, options, and futures.  When I was younger I was also taking 0% 1.5-2 year non fee credit card balance transfer offers (and writing a check to my broker), but those offers aren't as generous as the used to be, and the size relative to my current portfolio size doesn't make it worth the effort.

 

If I had access to long-term non-recourse debt I would be more aggressive.  If anything, you can keep it invested in lower-risk items as dry powder until an opportunity presents itself. 

 

How/where are you getting these LOCs and non-recourse loans?  What sizes can you get?  Ive seen "personal loans" offered, but these are generally limited in the 5-digit range and carry ~10%ish interest rates. 

[CorpRaider]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

 

The ETFs are structurally flawed, in that they have to unwind the leverage daily.  I think there's a thread on here discussing their problems and higlighting them as a short opportunity.  CEF's usually just issue preferred stock for their leverage and obviously aren't redeemable and don't settle up daily.

I don't think daily rebalancing is a problem (except for the trading costs). Sure, volatility in returns is going to affect your final performance because of how compounding works, but it doesn't make money disappear.

 

 

I dunno, FINRA has put out a warning fiduciaries that they probably shouldn't be held for more than a day (i.e., you will get your ass sued off, so stay away).  I haven't done much inquiry into the matter and do not purport to be expert on the subject.  Whenever a self-regulatory body flags something as too risky, I just put it in the "too stupid" pile and move on.  Manual of Ideas had an interview with quant on their podcast talking about the structural flaws and time decay of these vehicles as a short idea and I believe there's a thread on this site discussing the same.  Here's a basic invstopedia article going over some of the problems with them.

 

http://www.investopedia.com/articles/exchangetradedfunds/07/leveraged-etf.asp

 

[tripleoptician]

Hi Watsa

 

I may have a unique situation but my wife and I both have "professional" unsecured LOC's for $200 K each at prime interest. I'm in the process of getting another corporate unsecured LOC for about $125K at prime based on its balance sheet. I can hopefully build this amount over time as the holding company balance sheet grows.

I also have our HELOC of up to $200 K at prime +.5%

So currently about $725 K of untapped leverage at a competitive rate.

[Uccmal]

I would say that now is the time to set up borrowing via Lines of Credit of some sort.  I would not invest any of it right now.

 

I am in the process of de-leveraging across the board.  I still use a little margin debt.  Until recently we carried a large balance on a Heloc, and a relatively significant mortgage.  We did a big reno on the house 3 years ago, and bought two cars ( both slightly used) in the last 3 years. 

 

This year I paid a big chunk down on the mortgage, zeroed three unsecured lines of credit, and have put a big dent in the Heloc.  No matter what anyone says interest rates are not going to stay this low forever. 

 

I have used significant debt in all of the above forms when conditions warrant.  My rough plan going forward in this environment is to exit all BAC leaps on the way to $25.00.  Exit all AIG leaps on the way to $80.00.  Some Leaps I will convert to keep the tax man at bay and collect the dividends as they grow.  I have warrants in JPM, BAC, AIG, and WFC.  Of those I will probably sacrifice the BAC in January and clear the HEloc. 

 

The Heloc is going to serve as my living expenses fund so I dont have to sell stocks when the market corrects.  I can buy instead.  In addition I am pulling in enough dividends to finance half my living expenses with Seaspan and RBS preferreds and some bank common stock.  Once I convert the Leaps I will likely be self sustaining on a dividend basis. 

 

No where in this plan am I investing very much.  I have been buying a small amount of Pennwest and will be studying it over the coming year. 

 

All of this is subject to change, of there is a significant correction, in the near term. 

[SharperDingaan]

Keep in mind that when you're young you have little to lose. Most (non fiduciary) professions are not going to penalize you for a BK. The BK is also self-correcting as you had to be repeatedly ignoring what you were seeing, & being told, & essentially failed because of immaturity. It will be difficult, but it was the best thing that could have happened to you, & it was fairly cheap, as you didn't have much to begin with. If you lost you have the rest of your life to recover, but if you won .......

 

Different story when you actually have something to lose.

 

Leverage is just risk, & some risk is a desirable thing; but it is a question of form & degree.

The extreme middle-aged person might have a 60/40 equity split, & no leverage - leaving the equity to generate the risk

The extreme older person might be 100% FI with a 80/20 quality split, & 20% leverage - leaving the leverage & bond quality to generate the risk. The unleveraged portion generating safe income, & the leveraged portion generating spread from the difference in asset quality.

 

SD

[tripleoptician]

Uccmal does this mean you are effectively leaving yourself with no/little cash cushion for a market correction and instead plan on using unsecured debt to purchase securities if the market correction opportunity arises?

How did you obtain your 3 unsecured LOC's? Was it based on your portfolio size?

[yitech]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

 

The ETFs are structurally flawed, in that they have to unwind the leverage daily.  I think there's a thread on here discussing their problems and higlighting them as a short opportunity.  CEF's usually just issue preferred stock for their leverage and obviously aren't redeemable and don't settle up daily.

I don't think daily rebalancing is a problem (except for the trading costs). Sure, volatility in returns is going to affect your final performance because of how compounding works, but it doesn't make money disappear.

 

Volatility in returns in daily levered ETF won't make your money disappear, but will make it very close to zero in the long run. Take a slightly extreme example. You lose 20% one day and make 25% the next:

 

Normal ETF: (1-20%)(1+25%)-1= 0%

2X Levered: (1-40%)(1+50%)-1= -10%

3X Levered: (1-60%)(1+75%)-1= -30%

 

Ignore the administration expenses you pay on the levered ETFs.

This is very simple math. This is equivalent to gambler's ruin. In the long-run, you lose money on average.

The more volatility the worse it gets. A better way to profit is to short them... if you can take on the return volatility.

 

Or short similarly levered ETFs (bullish vs bearish) against each other if you can find borrows and cost of borrow is cheap enough.

[Lance]

Volatility in returns in daily levered ETF won't make your money disappear, but will make it very close to zero in the long run. Take a slightly extreme example. You lose 20% one day and make 25% the next:

 

Normal ETF: (1-20%)(1+25%)-1= 0%

2X Levered: (1-40%)(1+50%)-1= -10%

3X Levered: (1-60%)(1+75%)-1= -30%

 

Ignore the administration expenses you pay on the levered ETFs.

This is very simple math. This is equivalent to gambler's ruin. In the long-run, you lose money on average.

The more volatility the worse it gets. A better way to profit is to short them... if you can take on the return volatility.

 

Or short similarly levered ETFs (bullish vs bearish) against each other if you can find borrows and cost of borrow is cheap enough.

 

 

 

yitech, I agree that the best use of these is as shorts.  I like to short TMV (Direxion Daily 20+ Yr Trsy Bear 3X Shrs) as bet on rising rates.  Also, as these vehicles seem flawed at best, I think it's likely to go down over time regardless. 

 

Thanks,

Lance

[Uccmal]

Uccmal does this mean you are effectively leaving yourself with no/little cash cushion for a market correction and instead plan on using unsecured debt to purchase securities if the market correction opportunity arises?

How did you obtain your 3 unsecured LOC's? Was it based on your portfolio size?

 

Not exactly.  As the markets are rising I am very slowly raising cash.  If there was a significant correction - lets say 25-30% which is not unlikely, I would take on SOME margin debt, which is secured, if you like, by untapped lines of credit.  Ot sounds riskier than it is because there is some counterbalance in RSPs and my TFSA.  During the 2009 bust my RSPs were down about 25% to the markets 50%. 

 

I have had margin calls on two instances, over 15 years, during the two phases of the 08/09 crash.  Both times were the result of selling puts which I no longer do at all.  Once I bought the puts back, at a loss, I had money to invest in Leaps.  It was an interesting time, but a situation I would rather avoid in the future.

 

As to the lines of credit themselves: It sounds kind of funny now but I just sort of collected them over time.  Got one from CIBC, then one from TD, then my Wife and I got one together from CIBC, then the Heloc from TD.  And they keep raising the limits all the time.  I could put a downpayment on a house in Toronto from the unsecured lines of credit at this point which is just ludicrous.  Like I said above, interest will rise sometime and debt wont seem so much fun then.

 

I think alot about tis stuff.  Its not really conventional portfolio management.

 

RE: Leverages ETFs.  I tried these drugs when they first came out in Canada to downside hedge my portfolio.  The things drift ever lower in value rather quickly.  The smart money back then was shorting them.  I am surprised they still exist.  Maybe they have their place to overnight hedge occasionally but as an investment the only people making money are the brokerages, and derivatives traders. 

[Hielko]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

 

The ETFs are structurally flawed, in that they have to unwind the leverage daily.  I think there's a thread on here discussing their problems and higlighting them as a short opportunity.  CEF's usually just issue preferred stock for their leverage and obviously aren't redeemable and don't settle up daily.

I don't think daily rebalancing is a problem (except for the trading costs). Sure, volatility in returns is going to affect your final performance because of how compounding works, but it doesn't make money disappear.

 

Volatility in returns in daily levered ETF won't make your money disappear, but will make it very close to zero in the long run. Take a slightly extreme example. You lose 20% one day and make 25% the next:

 

Normal ETF: (1-20%)(1+25%)-1= 0%

2X Levered: (1-40%)(1+50%)-1= -10%

3X Levered: (1-60%)(1+75%)-1= -30%

 

Ignore the administration expenses you pay on the levered ETFs.

This is very simple math. This is equivalent to gambler's ruin. In the long-run, you lose money on average.

The more volatility the worse it gets. A better way to profit is to short them... if you can take on the return volatility.

 

Or short similarly levered ETFs (bullish vs bearish) against each other if you can find borrows and cost of borrow is cheap enough.

No. You also gain more when volatility is positive.

 

Normal ETF: (1+20%)(1+20%)=+44%

2X Levered ETF: (+40%)(1+40%)=+96%

 

What these things do is simply change your leverage (in a dynamic way). They don't have negative alpha (besides management fees or possible trading costs).

[yitech]

Yeah, the use of margin instead of another form of leverage is scary. I wouldn't mind a fixed rate loan for the net-net strategy I'm interested in, since I feel confident it will do better than the rate over a 5+ year timeframe. But needing to watch IB like a hawk with margin: no thanks.

 

How does a fund employing leverage differ from the leveraged ETFs? Just that the magnitude of swing isn't as great?

 

The ETFs are structurally flawed, in that they have to unwind the leverage daily.  I think there's a thread on here discussing their problems and higlighting them as a short opportunity.  CEF's usually just issue preferred stock for their leverage and obviously aren't redeemable and don't settle up daily.

I don't think daily rebalancing is a problem (except for the trading costs). Sure, volatility in returns is going to affect your final performance because of how compounding works, but it doesn't make money disappear.

 

Volatility in returns in daily levered ETF won't make your money disappear, but will make it very close to zero in the long run. Take a slightly extreme example. You lose 20% one day and make 25% the next:

 

Normal ETF: (1-20%)(1+25%)-1= 0%

2X Levered: (1-40%)(1+50%)-1= -10%

3X Levered: (1-60%)(1+75%)-1= -30%

 

Ignore the administration expenses you pay on the levered ETFs.

This is very simple math. This is equivalent to gambler's ruin. In the long-run, you lose money on average.

The more volatility the worse it gets. A better way to profit is to short them... if you can take on the return volatility.

 

Or short similarly levered ETFs (bullish vs bearish) against each other if you can find borrows and cost of borrow is cheap enough.

No. You also gain more when volatility is positive.

 

Normal ETF: (1+20%)(1+20%)=+44%

2X Levered ETF: (+40%)(1+40%)=+96%

 

What these things do is simply change your leverage (in a dynamic way). They don't have negative alpha (besides management fees or possible trading costs).

 

Well, here you are assuming you will tend to have more upside volatility while I believe there exists similar downside volatility that roughly cancels out upside volatility over time or in other words, mean reversion in volatility.

 

What you describe may happen over a brief period of time. This is why levered ETF is only good for short term speculations and in the prospectus it's why they put potential risk of capital loss due to volatility decay caused by compounding.

 

If you are so good at predicting upside volatility, I don't think you need any leverage at all.

[yitech]

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

[bargainman]

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

 

Right, remember Warren Buffett's protege who wanted to get there quick and blew up?  Can't remember his name..