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Two Yale economists, Ian Ayres and Barry Nalebuff, suggest in a recent book that young investors should use leverage to compensate for their lack of assets and through this mechanism, build larger nest eggs. But this strategy not only increases the final amount, it also does so with less risk (2% less standard variation in the portfolio). You can read about them talking about their research in this recent article from Time.
They also point out the prejudice most people have about leverage when it comes to stocks versus houses. That while most people don’t think twice about using 10:1 leverage to buy a house (or more) they cringe at the thought of just 2:1 when it comes to stocks. But the obvious difference is that while one is marked to market every day, the other isn’t. This allows a patient investor in real estate to ride out a short or even medium term price drop. In contrast, a stock investor can’t ignore a margin call.
Ayres and Nalebuff suggest using leveraged financial products, like the ProFund UltraBull mutual fund (ULPIX). But the problem is that while their theoretical framework may be logical, it breaks down when you try to implement it in the real world. This is due to valuation drift caused by the futures market as well as the rather high expense ratio of such funds (1.65%).
In this previous discussion we looked at the valuation drift between the US Oil Fund (USO) and crude oil due to changes in the futures market. The goal of the USO ETF is to replicate a leveraged exposure to crude oil every day - the key being that short time frame. But if you are long for any length of time longer than that, small variations begin to erode the connection between the derivative and its underlying asset.
We see something similar when we look at the financial product the two Yale economists suggest. The ProFund UltraBull mutual fund is very similar to the ProShares Ultra S&P 500 (SSO). When we look at short time periods, the leveraged funds do outperform. For example, during the past year’s bull market the ProShares (SSO) and UltraBull fund have almost doubled while the SPY has gone up about 40%.
But when we look at intermediate to longer term time horizons, as the strategy requires, then the valuation drift begins to deteriorate the strategy. Here’s a chart of the ProFunds UltraBull mutual fund showing what would hypothetically happen if a young bright eyed and bushy tailed new investor followed the advice in early 2006:
As you can see, it has fallen much more than the S&P 500 and has not been able to climb as much as the S&P 500 has. Here is another chart, slightly shorter time horizon, for the ProShares S&P500 leveraged ETF (SSO) showing the exact same scenario:
Click to see a larger version in a new tab:
So the reality is that using leverage may be beneficial but I don’t think we have the financial products that would actually allow us to do that. In the meantime, if you’re going to take positions in leveraged ETF’s make sure you’re using it as a short term rental for either day trading or swing trading. For those curious, here is the full research report by Ian Ayres and Barry Nalebuff:
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