The importance of establishing your investing decisions on Excel models instead of ‘feelings’ or opinions, reminder #452. It took me more than a week while working on a post titled “one year of leverage” to realize that, actually, I opened the Interactive Broker account in 2020 and not 2021.
I decided to trade with IB in 202X because they allow me to trade on margin easily and (relatively) cheaply, meaning I can use my positions as collateral to buy even more securities. If this sentence made your stomach turn, I suggest you read my whole past series on leverage (here, here and here).
“I am too lazy to go back and read your past stuff, why did you do it?”
Here is a handy example from OptimizedPortfolio.com:
Portfolio2 represents the standard All Weather: it has a pretty great Sharpe Ratio but, as a lot of people love to remind you, no one eats the SR. What you eat are returns and in that sense, the AWP offers lousy ones (unless you took the Pietro Michelangeli pill).
Leverage allows you to achieve Portfolio 1 results: a Max Drawdown in line with the standard 60/40 associated with almost double the profits. Now you have a great Sharpe Ratio and eat it too.
Money for free
After a decade of zero to negative yields, using leverage was more or less openly promoted by Central Banks. In a way, almost any strategy that was producing a positive return was fair game, the hurdle was that low.
If one day rates normalize, I thought, I would deal with the issue then. Well, not only that day arrived but rates rose, and will most likely continue to do so, at a speed that I thought was impossible to materialize. I started to ask myself if it still made sense to use leverage, given the circumstances.
This question is also linked to another issue I knew I had but I always pushed away because…well, markets are going up, why should I worry? Ok, I was only partially that superficial. I still have a job, two kids and 99 other problems, this one would be managed with the old trick of “do not bet the house until you are 100% sure”. Indeed, I did not move all my liquid net worth to IB and levered the shit out of it, I built the portfolio over time and I am not even close to the final amount I would like to invest.
If I want to close my leverage, I have to either sell part of the portfolio or direct new funds toward the loan repayment. Would it make sense to do it now that my portfolio value is off its high (but still positive)? I can also buy assets at lower valuations and drive the leverage down over time. Does the current situation require immediate action?
I spent a fair amount of time pondering solutions to these questions when I read this post from FireVsLondon. I do not have definitive answers yet, but it is excellent content for a post.
Living on a margin
At which point the cost of leverage is too high?
If X is the return of the strategy and Y is the leverage cost, as long as X>Y I am fine. But defining X is not that easy. I am running a portfolio that can be loosely equated to the 60/40, can past returns offer a good proxy for that? Do my adjustments offer a premium or a discount compared to that? The mature approach is to apply a safety margin: when rates were at zero, my cost of funding was close to the IB margin, 1.50% (yes, my portfolio is that small). So it did not really matter if my strategy was returning 4% or 6% or 10%: the distance with 1.5% was big in any case.
Right now Fed Funds are forecasted to peak at 3.3% (if I remember correctly, I am on holiday and left Bloomberg at home). Including the IB margin, soon my leverage is going to cost me 4.8%. There it goes my margin of error. Historically speaking, 3.3% is not even that high; I still remember when Jean-Claude Trichet set rates in Euro at 4.25%. So talking about a margin of error, it would be not that crazy to plan for even higher rates.
Ben Carlson recently wrote a post that helps put things in the right context.
These graphs are taken from the Credit Suisse Global Investment Return Yearbook and show real (above inflation) returns of stocks, bonds and US Treasury bills for the USA and World ex-USA. It is important I look at both because my portfolio is a blend of the two but as you can see, the difference is not that big for the period 1900-2021 (ok, US stocks did way better than World but I would explain later why this is not that important).
My total cost of leverage should be close to US Bills + 1.30%; in fact, US Bills normally trade at a premium of at least 20bps to Fed Funds, the benchmark rate for IB margin loans. This means that in the past, only a portfolio of c100% World Ex-USA bonds would have generated a return lower than my cost of leverage. This exercise is crucial to put the 1.5% IB margin in the right context: it is not outrageous but it still leans on the expensive side (the margin on my floating mortgage was 89bps, to say…a loan that should be riskier than the IB one). Never underestimate the power of brokers’ marketing dept. to make you believe you are getting a bargain.
In reality, my leverage cost is lower than above because my borrowings are a mix of USD, EUR and sometimes GBP. I do not have 100% freedom to manage this on IB because I can only sell currencies where I hold a positive balance: if my starting position is $-1k and £0, and I cannot buy $1k and move the short position into £. I think IB designed this to avoid people borrowing in JPY or CHF to buy USD assets, a trade called “the widowmaker” for a good reason. The asset-liability currency mismatch can magnify gains but also losses in a risk-off period.
[This might not be 100% correct because I think I can buy an ETF that holds USD assets but is listed in Switzerland to create a long USD/short CHF position but anyway, not the type of risk I am in the market for. In the long term, this carry trade should pay off but the short-term whipsaws can be violent]
The Credit Suisse yearbook delivers added comfort in that all assets under consideration provided above inflation returns…in the long run. This makes sense because investors, even if they can be caught with their pants down by an unexpected and massive increase in inflation in the short-term, should demand higher future returns that can compensate them for the inflation risk.
Leverage: starting level and adjustments
Having read about the perils of leverage before I started trading, I always applied a gradual approach: start small and ramp later (if everything is going according to plan). As you noticed in this post, I do not ask all the relevant questions in advance, because I am impatient and lazy. At least, this approach allows me time and resources to correct course once issues arise. It is not the best but I prefer learning by doing (while getting a bit burnt). Ages ago I traded FX on platforms that were offering me 1:100 leverage: compared to that, IB is a very blunt instrument.
I started with a 1:1.25 leverage, targeting 1:2. I received the first margin call at c1.36x, ok….
The size of my portfolio is too low for IB to allow me for portfolio diversification: I do not get any benefit, from a leverage point of view, from the fact that I hold uncorrelated assets. Each trade counts on its own and some of my positions linked to Emerging Markets cannot be even margined. Given that the Initial Margin is up to 50% and the Maintenance Margin is lower at 25%, I should be able to leverage at least up to 1:1.5 but I think these rules apply only at the end of each day; during the day, IB most likely uses a model that takes into account each position expected volatility, therefore the noticed I received about a possible margin call.
I am running a 1:1.3 leverage target now. I can stay relatively close to that 1.36 because I add to the strategy on a monthly basis and I have funds in my ISA, where I hold the “income” part of the strategy for tax reasons: in case there is a dramatic move in the market, I can provide liquidity pretty fast.
Given that my positions move on a daily basis, also my leverage drifts higher or lower. In a bull market, my leverage goes down because the value of my assets increases while the nominal value of the loan stays put. IB allows me to buy additional securities “for free”, without me transferring cash to the portfolio. But if I buy this way, I buy at higher and higher valuations. On the other side, when the market crashes, my leverage goes up and the cash I provide goes against my loan balance, not to buy securities that trade at a ‘discount’.
How often should I reset the leverage to target? The problem lot of investors have with levered ETFs is related to this question. A 3x S&P500 ETF reset its leverage to 3x at the end of each day and this magnifies losses, and gains, compared to a strategy that set the leverage at inception and never touches it again. As you can see below, an investment in UPRO, a 3x S&P500 product, delivered gains higher than 3x compared to the plain vanilla SPY over a 12 years period:
This is basically related to how gains and losses compound in the two different scenarios.
The optimal leverage targeting strategy depends on the characteristics of the asset or portfolio of assets I invest into: the more it trends instead of mean-reverting, the better it is to reset the leverage more frequently (…I guess?). Obviously, the asset/portfolio has to provide positive expected returns, otherwise the leverage just accelerates the speed at which the strategy goes to zero.
This is the reason why I concentrate on portfolios that exhibit shallower drawdowns and lower Ulcer Index: here leverage and a higher frequency of leverage targeting works best. The good news of running a portfolio of uncorrelated assets is that every month I add to the asset that performed the worst, therefore limiting the risk of adding at higher valuations (at least in relative terms).
My journey in the leverage space made me realize how affected I was by the scaremongering around levered ETFs. The right products, in the right context, provide leverage in a very cheap and convenient way.
Loan vs FIRE
Days ago, Liquid Independence wrote this post about quitting his job to effectively pursue the FIRE life. That piece made me think about this tweet:
Liquid’s retirement plan is to fund his expenses not by selling his investments but by borrowing against them. I read somewhere that this strategy is called “loan FIRE” but I tried to Google it on a later day and found nothing…anyway, conceptually is nothing different from what I am doing. If the asset you own returns 7% and you can borrow at 4%, borrowing is a more efficient choice than selling.
Congratulations, we solved financial planners’ biggest problem and can all retire happily ever after. Unfortunately, reality is a bit more complex than this. Enters “sequence return risk”, the risk of receiving lower or negative returns early in a period when withdrawals are made from an investment portfolio, something we already discussed in this blog. Stocks are a great financial instrument for creating long-term wealth but they have this nasty habit of losing 30, 40, or even 50% every now and then. If you start to borrow against them and then their value drop substantially, not only your wealth is halved but now you have creditors knocking at your door.
As I discussed previously in this post, you can estimate with a certain precision your investment returns and borrowing costs in the long term but what happens in the short term represent the real ruin risk. Sometimes, the pain is not even that short: since 1930 there have been two decades, the 30s and 2000s, when the S&P500 produced negative returns. If the borrowed amount is not enormous, “lost decades” might not bankrupt the investor (they are only losing interests paid on the loan) but would represent a greater psychological challenge to stay invested.
It is true that rich people borrow against their stock holdings instead of selling…but their situation is not comparable to a regular lad retiring (even if he’s a millionaire). First and foremost, multiples over their basic needs are covered by other sources of income; they borrow to buy other assets, usually real estate, not to fund current expenses. They have a personal relationship with the bank originating the loan (if they do not own it outright) and therefore have more control over it, their borrowing costs are very cheap (but in this, IB is really competitive) and they have tax advantages.
Loan FIRE might be another twist of holding a liquidity bucket at the beginning of your retirement and then withdraw only from there, the “rising equity glidepath” I wrote about here. The main commonality is that both strategies allow the investor to avoid selling stocks when the market is down; the biggest difference is that you have to prepare your liquidity bucket in advance, the standard glidepath, while you can always plug-in the borrowing, provided you created the relationship with a bank. Going back to the tweet I linked above, there might be a recency bias component that drives investor toward Loan FIRE…where by recency I mean the last decade and not the last six months; stocks have been in a strong bull market, loan rates were low and yields on cash even lower. If an investor is planning to retire soon, building a liquidity bucket with monthly savings might be a good strategy given the circumstances: yields are going up and the cost opportunity of staying out of stocks is getting smaller and smaller. On the other side, Loan FIRE might be getting more dangerous, considering borrowing costs are increasing and God knows where the stock market will end up after this inflation shock.
Liquid is correct in assuming that in most cases he will be fine pursuing this strategy. As everything involving leverage, the issue is not the base case but what can happen on the left side of the outcomes distribution.
What I am reading now:
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