Opinion

Felix Salmon

Levering up your retirement account

By Felix Salmon
April 16, 2010

Barbara Kiviat has a Q&A with Ian Ayres and Barry Nalebuff, who have taken their paper explaining why young people should buy stock on margin, and have turned it into a book.

I liked — and still like — the fundamental idea here, which Nalebuff sloganizes very well:

Another way of saying it is we believe in stocks for the long run, but most people when they have lots of stocks don’t have the long run and when they have the long run don’t have lots of stocks.

What I’m not at all sure about is the practical mechanics of doing this:

Ayres: That’s a good question. If 2-to-1 is great, why not go to 3-to-1 or 4-to-1? The answer is, the cost of levering becomes too expensive. One of the great pieces of news in this book is that it’s really cheap to borrow money to take levered positions in stock at a 2-to-1 rate. But if you go beyond 3-to-1, it gets prohibitively expensive to borrow money…

Over the past 138 years, the wholesale lending rate for margin loans was just 0.34 percentage points above the T-bill rate. Don’t do it from Vanguard or Fidelity — they don’t have competitive margin rates. But if you shop around places like Interactive Brokers, you can basically borrow very close to the T-bill rate, if you stay at a 2-to-1 basis.

Nalebuff: It’s also possible to do this via long-term options. Ideally, this idea will catch on and there will be funds that do it for you. Today there are a few, like the Ultra Bull fund from ProFunds.

There’s a lot not to like here — starting with the idea of 20-year-olds opening up margin accounts at Interactive Brokers, and continuing with the fact that things like the Ultra Bull fund have a tendency to underperform the stock market even when the stock market is rising. When I first wrote about this idea, I quoted John Waggoner, who pointed out that over the previous five years, the Ultra Bull fund was up 8.8%, while the S&P 500 was up 18.6%.

That was in April 2008, when the Ultra Bull fund was trading at about $60 per share. Since then, it fell to less than $15; it’s still under $40. The fund has high fees; what’s more, it exacerbates the fact that stocks are volatile, and that if you go down 10% and then up 10%, or up 10% and then down 10%, you end up lower than where you started. While I like the idea of adding a bit of leverage to your portfolio when you’re young, I don’t like the idea of doing so via an ETF like this one, and I’m very worried about the fact that Nalebuff is citing it as a possibility.

More generally the amount of discipline that you need in order to successfully prosecute this strategy is absolutely enormous, and human beings tend not to be particularly financially disciplined, especially when they’re young. They’ll abandon the buy-and-hold strategy at exactly the wrong time, selling low and then buying back in at high points; they’ll start using their margin account to try to pick stocks or trade options; they’ll use any profits on expenses rather than keeping them invested and letting them compound.

Meanwhile, of course, the Wall Street institutions letting you borrow on margin are going to be encouraging you to do all those things, while making it as hard as possible for a 20-something to get anything near “the wholesale lending rate for margin loans”.

I haven’t read the book, and so I don’t know how much detail it goes into with respect to actually doing this in reality. But if the best that the authors can come up with is a strategy of buying and rolling over deep-in-the-money LEAP call options, I wouldn’t recommend this to anybody except the extremely financially sophisticated. Who are probably going to make lots of money over their lifetime anyway.

Update: David Merkel adds good points.

Comments
7 comments so far | RSS Comments RSS

I was a 20 something back in the 90′s bull market working in tech. I remember the margin calls that blew up a lot of my friends (I didn’t have the stomach for it). QCOM at $1000 anyone? Blodget and gang at their best indeed… The brokers at the time didn’t even bother to (margin) call, they just sold everything and in some cases stuck their customers with a bill.

Plus ca change, plus c’est la meme chose ;-)

Posted by magicrf | Report as abusive
 

More to the point, if you go down 10% and then up 11.2%, you’re back to even, while if you go down 20% and then up 22.4%, you’re not. The rebalancing is part of the problem, even aside from the increase in fees it entails; if you borrow $10 to finance $20 in equities, and that goes to $22, you need to borrow another $2 and buy another $2 in stock to keep the 2:1 ratio; similarly, you sell the stock when it drops. Buying high and selling low works poorly when the market is bouncing around a trading range.

An ETF that consisted of long-dated, well into the money options would be better for young retail investors, but would be harder to explain than “each day we return about twice what the index does”. This may be a situation where simple marketing triumphs over substance.

Posted by dWj | Report as abusive
 

I worry about the systemic effects of that: More leverage would (I expect) make the markets more volatile, and wipe out the savings of a number of young investors. Some other investors would do much better, but increasing the variance of the outcomes seems like more of an unfortunate consequence than a goal.

There are certainly some strategies that have similar effects, but they’re very much sophisticated-investor sorts of strategies. The proper leverage for a non-expert is no leverage at all. No leverage is frequently a good idea for experts, too.

Posted by jleonard | Report as abusive
 

It is my understanding that it is the underwriter’s obligation to disclose all factors relevant to a new security issue in something called a prospectus. But, Wall Street had no obligation to present a prospectus because these new and complex securities were being sold only to “sophisticated investors” throughout the world. GS only used marketing materials, and it is going to be very difficult for the SEC to prove any criminal case.

Posted by TwoTall | Report as abusive
 

>>”An ETF that consisted of long-dated, well into the money options would be better for young retail investors, but would be harder to explain than “each day we return about twice what the index does”. This may be a situation where simple marketing triumphs over substance.”

I’m a young (23) retail investor with very little liquid capital to invest. This article really caught me by surprise because I’ve always heard that, and agree with, the fact that “debt = bad”. However, I’ve additionally wondered how much of an effect the $2000.00 I have invested now in various individual stocks and an S&P 500 index fund will have on my life in the long run.

With such little money invested, I increasingly feel as though I’m “working” for the brokerage. Is there really an ETF like the one you listed above? If so, can you point me in the right direction?

Posted by HbrwHmmr | Report as abusive
 

Rydex has had 150% and 200% (as well as -100% and -200%) levered index mutual funds for over a decade now. The expense ratios can’t beat ETFs, but once interest rates start climbing, it’ll be cheaper than borrowing on margin.

Posted by Ekb | Report as abusive
 

I don’t agree with Ayres and Nalebuff:

http://alephblog.com/2010/04/17/dont-buy -stocks-on-margin-unless-you-are-an-expe rt/

Nor does Roger Nusbaum, who is too kind to me:

http://randomroger.blogspot.com/2010/04/ maybe-you-can-buy-and-hold.html

Posted by DavidMerkel | Report as abusive
 

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