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Beware Academics Bearing Financial Advice at Trader’s Narrative

Beware Academics Bearing Financial Advice

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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:

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ProFunds UltraBull compared to SPY long term chart Apr 2010

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:
SSO SPY performance compared 3 year chart Apr 2010

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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3 Responses to “Beware Academics Bearing Financial Advice”  

  1. 1 John Butters

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    I have had a quick look at these funds and it looks like they apply 2x leverage to daily price moves — this is how these things usually work. This is the key point that the academics have not grasped.

    Let’s put this in terms of houses. Imagine you buy a $100,000 house with a 50% mortgage, putting in $50,000 of your savings. One day, the value of your house falls by a third. The value of your house is now $66,666, and your equity is $16,666. The next day, the value of your rises by 50%. The value of your house is now $100,000 again, and your equity is $50,000.

    Now imagine you buy the house with 2x daily leverage. On day one, the value of your house falls by 1/3, and the value of your equity falls by a factor of 1/3*2=2/3. The value of your equity is therefore (1-2/3)*$50,000=$16,666. On day two, the value of your house rises by 50% (1/2). Your equity rises by a factor of 1/2*2=1. The value of your equity is therefore (1 1)*$16,666=$33,333. You are not back where you started.

    Why does this happen? Because your leverage ratio is kept at 2x. In order to run our second scenario in the real world, at the end of day one you would have to sell a share in your house in order to pay down some of the mortgage, in order to keep the same leverage ratio on an asset that had dropped a third of its value. If you buy one of these leveraged equity funds, you are effectively forced to crystallise losses on the way down. A big enough negative move could mean permanent loss of capital, even for a long-term holder.

    I use leverage myself every day, but I know it is very dangerous and I handle it with a lot of care. For retail investors, I would recommend a simple rule: run a mile from anyone who even suggests using leverage in your investments.

  2. 2 Dan Smith

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    There is another chart you should have posted: the chart of “Market Timer’s” net worth. Market Timer is the screen name of a member of an investment forum, who read Ayres and Nalebuff’s 2005 article “Mortgage Your Retirement” and decided to apply it. As a graduate student in economics, he is at least as capable of executing the plan as any twenty-something worker. The story is summarized at the beginning of the thread

    In 2008 he lost $200,000 in borrowed money which is slowly repaying. He says he probably will never invest in equities again. His net worth chart is here

    He’s mentioned in Ayres and Nalebuff’s book, where they explain that he wasn’t doing it right.

  3. 3 Babak

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    Dan, thanks for pointing that out. Yes, in their book they say that he should have sold and crystallized his losses, just as John writes in his comment above. The problem, of course, is that while this may reduce the amount of total losses, it also reduces your ability to get back what you’ve lost. I’m also puzzled by their criticism of his “excessive leverage” since they suggest using even higher leverage 3x or 4x if possible.

    But even if we give them the benefit of the doubt and readily accept what they say here:

    “Following our advice, Market Timer might have lost $50,000 - a bad outcome but one that would have left him with $30,000 in the bank and a chance to participate in the 2009 recovery.”

    … it still does not make up for the fact that the financial products (leveraged ETFs) produce a valuation drift that makes the portfolio lag badly behind the index it is tracking.

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