Leveraged Lifecycle Investing - Australian application

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Dylan_Goatman
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Leveraged Lifecycle Investing - Australian application

Post by Dylan_Goatman »

Official website: http://lifecycleinvesting.net/

[Link removed by admin LadyGeek]

Introduction:

The main benefit to broad index fund investing is diversification, which reduces concentrating your risk to a few individual stocks, sectors or markets. Leveraged lifecycle investing essentially takes this further, and attempts to allow investors to diversify over time.

For those of you thinking that to DCA into ETFs is the best way, this book challenges this idea and provides data to back it up, including through monte-carlo simulations which are independent of past market performance. Supposedly, this strategy reduces risk by 21% (Variance from mean) with the same final valuation, or improves median valuation by ~60% with the same risk.

The authors ran simulations for this strategy on the Japanese markets (Nikkei), UK markets (FTSE All-Share) and the US, all of which saw significantly improved returns over all historic market ‘lifetimes’. Data can be viewed here http://lifecycleinvesting.net/data.html

The problem:

As I am sure many of you are aware, the future of your retirement can depend heavily on sequence of returns risk https://www.forbes.com/advisor/retireme ... urns-risk/.

This is where upon entering retirement and drawing down on your (presumably) ETF/Bond portfolio, the magnitude and timing of market returns during the first few years are crucial to your portfolio’s longevity.

According to the leveraged lifecycle investing strategy (As I understand it), this risk can be reduced by better diversifying your exposure to volatile investments like stocks over your lifetime. They propose the following assumptions/main points:

Your total exposure over time to the market can be measured as your ‘dollar years’ of exposure, where exposing $1 to 1 year of the market is equivalent to 1 ‘dollar year’.
Across your lifetime, due to the compounding nature exhibited by most FIRE portfolios, the vast majority of your ‘dollar years’ of exposure are towards the last few years before retirement.
This total market exposure is consequently heavily over-weighted to the years prior to retirement/drawdown.
In the first 5-10 years of investing/accumulation, your portfolio value is disproportionately small, and hence so is your ‘dollar year’ exposure.
During the middle of your investing period, your exposure is as expected.
Towards the end of your accumulation and start of retirement period, your exposure is much higher due to having a far higher portfolio value.

The above points take into account the effects of reducing stock exposure over time (Such as from 100% at the start down to 60% at retirement). Either way, you have much more exposure towards the end of your investing timeline than the start.

Potentially, this exposes investors to a ‘Sequence of returns’ risk, due to heavy over-weighting during the early retirement years, as mentioned above.


Proposed solution:

The authors propose a fairly simple sounding solution; utilise leverage in your early accumulation years to compensate for the reduced exposure, and lower stock weightings in your final portfolio to compensate for overexposure at retirement.

There are 3 main strategies they mentioned to achieve this. Please note, the authors recommend lowering your leveraged amount if the market drops to reduce your risk. If the market was to drop too much and you hadn’t lowered your leverage amount to reduce risk, you could potentially lose everything. Counter-intuitively, this would mean you have to buy as the market is climbing, and sell down as the market is dropping. For example, if you were leveraged 2x, you could have $50 of your own money and $50 of ‘borrowed’ money invested. 1:1 ratio, 2x leverage.

If the market dropped 25%, you would then have $25 of your own money invested, and $50 of borrowed money invested. 1:2 ratio, you would be 3x leveraged. This is where the book and data suggests things get risky, and to reduce any further risk of bankruptcy, the authors strongly, strongly recommend staying between 1.5-2x leverage, and ALWAYS ensuring you are close to that range.

1. Options

Buying 50% ITM LEAP call options on stock indexes/ETFs. This would provide exposure to 2x the index performance over a relatively long time period (2+ years), with approximately ~4% ‘interest’ equivalent in the form of options premium.

As an example, a SPY (S&P 500) Call with a $220 strike price expiring in Jan 2024 currently costs $237.85 https://finance.yahoo.com/quote/SPY2401 ... 9C00220000

Since SPY is currently priced at $446.75, this means the cost of the call is made up of $226.75 profit (Since SPY is $226.75 above the strike price), and $11.10 in premium. This premium is essentially the cost of having the exposure, determined by volatility and the time until expiration.

In all, 11.1/237.85 = 4.6% premium, ie the cost of 2x leverage is 4.6% for this call option example.

To reduce leverage during a market crash, you could sell your current option and buy a different option at a strike price closer to 50% of the new index value (Which will be lower).

The main problem with options (from my understanding) are:

Liquidity, particularly in Australia if trading on the ASX through ETF options
Taxation, since calls will either have to be exercised (Buying the underlying at the strike price) or sold (Taking your profit directly). If you exercise, in order to continue to leverage your portfolio you will need to sell. Both of these will result in a taxable event, which I assume (I haven’t done any calculations) will make the strategy unfeasible.
Severe and sudden market crash (>50%) causing your calls to expire worthless. This can be avoided by lowering your leverage as markets drop.

What are your thoughts on leverage through options like this? Are there any potential loopholes/rolling-over etc strategies to reduce/eliminate the taxation issue? Would trading directly in the US markets improve liquidity, and would taxation/currency/brokerage implications outweigh the benefits?

2. Futures

I personally have never traded futures, but have an understanding of the basics of how they work. Could anyone with more knowledge please share what brokers/platforms/markets are best to trade futures in?

Similar to options strategy, you could buy a futures contract at approx 50% of the current index value. This would be priced at the difference between the strike price and the index, plus whatever the premium is based on volatility/time to expiration.

Again, the reduce leverage during a crash you could sell your contract, and buy a different one closer to 50% of the new index value, bringing you back to 2x leverage.

Similar to the options problems, taxation and liquidity are the main obstacles for Australian investors from my understanding.

3. Margin/Borrowing money

I don’t think I need to explain how borrowing money to invest works. Basically get a loan and invest. Interest will depend who you borrow from, how much you borrow and what assets you have backing loan. Currently, the NAB equity builder loan charges 3.75%, but the normal rate is 5.75%, barely above the expected return and not worth the interest IMO. https://www.nab.com.au/personal/super-a ... ty-builder

Where to next?

So the main ‘plan’ proposed would be to calculate your final stock allocation value (e.g. 50% of a $1,000,000 portfolio, ie $500,000) and invest at 2x leverage until you reach that level of exposure. In this example, that would mean once you have $250k invested at 2:1, giving $500k worth of stock exposure. From here, you allow the assets to grow, reducing the leverage over time to ensure you always have that $500k worth of exposure. If the market crashes and you have less than that, you would raise the leverage amount (up to 2x) and continue the same until you reach that level of exposure.

From there, you begin accumulating your other assets (Bonds for example) normally until they reach your desired allocation, and you retire nice and happily.

I have simplified the above paragraph, so it isn’t 100% true to how the book calculates the share of stock you should own at retirement, but the concept is the same. Leverage during growth, once you hit your target exposure you leverage down and begin accumulating your other assets.

Final thoughts:

Hopefully that all made sense and I’ve summarised the key concepts correctly. I would love to know your thoughts on this strategy and solutions to practically applying the strategy given Australian liquidity/taxation.

I believe the book was written for a US audience, who can use a Roth IRA or some sort of other tax-free account to execute the plan more efficiently. For Aussies like myself, unfortunately our Super funds are not allowed to invest in leveraged products as far as I could research, but I’d love to be proven wrong on that.

This is the first post of this type I’ve made. I’d love to learn more about alternative investment strategies like this so please leave a comment or DM me if you have any other book/strategy recommendations. I’ve also read a lot about the HFEA (HedgeFundie’s Excellent Adventure) strategy, which I am also considering making a post about, particularly how to replicate 3x treasury bonds effectively in an Australian (ASX) environment, and how the strategy would stack up with (presumably) rising interest rates.
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Re: Leveraged Lifecycle Investing - Australian application

Post by LadyGeek »

Welcome! The wiki has some background info: Life-cycle finance
Wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.
Valuethinker
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Re: Leveraged Lifecycle Investing - Australian application

Post by Valuethinker »

Do not borrow money to invest - do not borrow on margin.

The reason is a margin loan can be called, and will be called at the worst time - at the bottom (ish) of a market downturn.

Then you are out of the market, and you will not have time to recover the lost wealth.

The only reason to use leverage is to take advantage of annual contribution limits which are quite common for tax deferred or protected accounts (like your Superannuation). Those are not usually recapturable - use or lose it.

Technically as a private investor, leveraged using stock margin, you are "short volatility" or short downside volatility. Winning in the long run in equity markets requires being long volatility-- riding the roller coaster. Equity markets have way more volatility than the volatility of the underlying cash flows (dividends and buybacks to shareholders) would suggest. That extreme volatility is also why markets pay high returns when they do go right. Risk and return are inextricably linked in this.

If we run the tape on the 20th century we see world war, global pandemic, Great Depression, global war, threat of nuclear conflict & "Cold War" (it was pretty hot if you got sent to Korea or Vietnam), oil crisis & global stagflation, collapse of USSR. Then you got to the 21st century with 9-11, dot com
crash, Global Financial Crisis, renewed tension between superpowers, North Korea as a nuclear rogue state, and now another global pandemic (likely the first of many) & environmental crises. For 10 years 2000-2010 markets went nowhere. It was not predictable in 1900 which stock markets (St Petersburg, Moscow, Vienna, Budapest, Berlin, Buenos Aires or Sydney, New York, London) would do well and which would do badly. What you have in the data is the survivors.

So markets reward the long term investor, but you have to stay in them long term.

The only borrowing which works is using home equity. As long as you stay employed or can rent the place out, you will not be called on leverage against your home. You can take that excess capital and invest it in stocks. Over say the 30 year life of a home mortgage, you are likely, but not guaranteed, to beat the interest cost. (Taxes play a big role in that calculation).
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andrew99999
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Re: Leveraged Lifecycle Investing - Australian application

Post by andrew99999 »

Valuethinker wrote: Fri Jan 21, 2022 9:15 am Do not borrow money to invest - do not borrow on margin.
Valuethinker wrote: Fri Jan 21, 2022 9:15 am The only borrowing which works is using home equity. As long as you stay employed or can rent the place out, you will not be called on leverage against your home. You can take that excess capital and invest it in stocks. Over say the 30 year life of a home mortgage, you are likely, but not guaranteed, to beat the interest cost. (Taxes play a big role in that calculation).
That's really the issue - callability — rather than borrowing to invest more generally.

Australia has a product for borrowing to invest that is designed not to be called in provided reapyments are being made on the loan. They restrict to diversified funds including index funds. They also restrict to a more moderate amount of borrowing if you have an interest-only loan (30%) as opposed to paying down the principle with the interest like on a mortgage (I think 70%). Of course, the downside is higher interest rates (3.75% currently vs low 2's for home loans). It is tax-deductible, so that helps a little, but still.
hithere
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Re: Leveraged Lifecycle Investing - Australian application

Post by hithere »

With regard to options, there are other strategies that allow you to lever up such as synthetic long stocks and short box spreads. You may want to look into those. Particularly the latter strategy results in no gains, so presumably it will solve the tax issue you mentioned.

With this amount of leverage, you're playing with fire, but I suppose that's the whole point of lifecycle investing. Good luck, I hope everything works out for you.
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Dylan_Goatman
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Re: Leveraged Lifecycle Investing - Australian application

Post by Dylan_Goatman »

[quote=andrew99999 post_id=6469074 time=1642913869 user_id=136732

Australia has a product for borrowing to invest that is designed not to be called in provided reapyments are being made on the loan. They restrict to diversified funds including index funds. They also restrict to a more moderate amount of borrowing if you have an interest-only loan (30%) as opposed to paying down the principle with the interest like on a mortgage (I think 70%). Of course, the downside is higher interest rates (3.75% currently vs low 2's for home loans). It is tax-deductible, so that helps a little, but still.
[/quote]

Thanks for your reply! Is this regarding the NAB Equity Builder program? I have had a look into this and it seems like a promising option. Unfortunately, they are no longer accepting applicants for it, but I have put my name down on the waitlist for a few months now. Hopefully they'll open it up again
Valuethinker
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Re: Leveraged Lifecycle Investing - Australian application

Post by Valuethinker »

andrew99999 wrote: Sat Jan 22, 2022 10:57 pm
Valuethinker wrote: Fri Jan 21, 2022 9:15 am Do not borrow money to invest - do not borrow on margin.
Valuethinker wrote: Fri Jan 21, 2022 9:15 am The only borrowing which works is using home equity. As long as you stay employed or can rent the place out, you will not be called on leverage against your home. You can take that excess capital and invest it in stocks. Over say the 30 year life of a home mortgage, you are likely, but not guaranteed, to beat the interest cost. (Taxes play a big role in that calculation).
That's really the issue - callability — rather than borrowing to invest more generally.
Yes. And I am hoping that was clear.

Otherwise, it's a matter of expected return - but after tax.
Australia has a product for borrowing to invest that is designed not to be called in provided reapyments are being made on the loan. They restrict to diversified funds including index funds. They also restrict to a more moderate amount of borrowing if you have an interest-only loan (30%) as opposed to paying down the principle with the interest like on a mortgage (I think 70%). Of course, the downside is higher interest rates (3.75% currently vs low 2's for home loans). It is tax-deductible, so that helps a little, but still.
I can't even begin to enumerate the moral hazard problems of financial institutions encouraging clients to leverage to invest in an inherently highly volatile asset class.

There's tax arbitrage. Canadians can borrow to take full advantage of their RRSPs (equivalent to Super) in a given tax year, then repay subsequently. That's a reasonable short term use of leverage.

Broadly leverage is not worth it. Unless you think call options are undervalued - so a portfolio of safe assets + calls can synthesize leverage. But time value counts against you and my sense (on little knowledge) is that for a non-professional options investor, this isn't going to work.

There is a lifecycle aspect and that's entirely fair. Trade your greater human capital potential off against limitations on investment capital (financial capital) now. But the problem remains (as above) what happens when we hit a protracted bear market? Or the market has downwards volatility greater than the assumptions based on history? We are back into the world of Taleb and "Black Swans" -- low probability, devastating events. Setting aside endless wrangles of what constitutes a black swan (does Ukraine count? This is has been going on for months). These events happen a lot more than the assumption of Gaussian normal distribution would predict.

That infamous line from the Goldman Sachs fund manager in August 2007 "This event only happens once in every 10 million years" (paraphrasing). He/ she doubtless meant in statistical terms, but it just conveyed a cluelessness about the "reflexivity" of markets.
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andrew99999
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Re: Leveraged Lifecycle Investing - Australian application

Post by andrew99999 »

Valuethinker wrote: Mon Jan 24, 2022 6:49 am
Australia has a product for borrowing to invest that is designed not to be called in provided reapyments are being made on the loan. They restrict to diversified funds including index funds. They also restrict to a more moderate amount of borrowing if you have an interest-only loan (30%) as opposed to paying down the principle with the interest like on a mortgage (I think 70%). Of course, the downside is higher interest rates (3.75% currently vs low 2's for home loans). It is tax-deductible, so that helps a little, but still.
I can't even begin to enumerate the moral hazard problems of financial institutions encouraging clients to leverage to invest in an inherently highly volatile asset class.
If it's not callable, what's the problem?
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