Borrowing money to invest is like weaving through traffic.  You'll get to your destination sooner as long as nothing bad happens. – MJ, 2020 The case for leverage (borrowing money to invest) seems compelling.  You can borrow money at 3-4% interest, and invest it in stocks that will probably make 6-8%.  What’s not to like? The answer is “the unexpected.”  Anything that forces you to sell your investments while they’re down can cost you a lot of money.  You could be forced to sell when you lose your job due to problems with your boss, your company, or the whole economy.  Or your lender could demand its money back.  You can’t anticipate every possible reason why your stocks might crash at the same time as you’re forced to sell. It’s true that such problems are likely rare.  But they don’t have to happen often to make leverage look like a bad idea.  Selling when your stocks are down 30% gives back a decade of expected excess stock gains above loa...

Last week’s article on Smith Manoeuvre risk sparked reader RS to ask the following thoughtful (lightly-edited) question: Have a mortgage and have non-registered investments (mostly in XIC) that can cover a significant portion of my outstanding mortgage. Wondering if it will make sense to pay off the mortgage using non-registered investments and take a HELOC and buy the same (or similar to avoid attribution) assets. I will be in the same position as I am now, but now I will be able to write off interest (which will be about 25% more in HELOC). My marginal rate is 50%, so I guess it might be advantageous. I will also need to factor in any capital gains taxes (25% of gains) that I will incur now against the savings. But this thinking sounds too simplistic. Not sure if I am missing something here. I don’t think you’re missing much. Given that you have had a mortgage at the same time as building non-registered investments, it would have been better to have set things up to make your...

The Smith Manoeuvre is a tax-efficient way to borrow against your home to invest more in stocks. This increases your potential returns, but also increases risk. Periodically, it makes sense to evaluate whether you can handle the potential downside. It’s clear that if you can follow the Smith Manoeuvre plan through to near retirement without collapsing it at a bad time, you’ll end up with more money than if you hadn’t borrowed to invest. The important question is how likely you are to be forced to sell stocks to pay your debts at a bad time. It’s easy to decide you’re safe without really considering the risks. I find that employees, particularly in the private sector, underestimate the odds of getting laid off. Most of the time, they’ll say it can’t happen. But it can. You can lose your job, stocks can fall, real estate prices can fall, and all 3 can happen at once. In fact, a single event could trigger all 3 bad outcomes. Anything that could cause stocks to drop 30% coul...

It’s common to hear that certain types of risky investments are not for novices. Some will take this to mean that such investments are good for experienced investors. This isn’t necessarily the case. A recent example of this type of advice is an article warning investors about quadruple-leveraged ETFs : “Investing in even modestly levered funds is a potentially dangerous proposition for inexperienced investors.” This quote is true, but some readers may conclude that these leveraged ETFs are safe if you’re an experienced investor. It’s worth reminding ourselves of a simple truth: if two investors buy the same investment for the same price on the same day, and they sell it for the same price on the same later day, they will get the same return. The more experienced investor won’t somehow get a better result. To perform better than novices, experienced investors must do something different from novices. Quadruple-leveraged ETFs are usually a bad idea for investors no matter th...

A reader, J.H. asks the following thoughtful question about leveraged ETFs (edited for length): I am familiar with the decay factor of leveraged ETFs over the long term. However, it seems that using 50% cash, 50% 2X ETF, rebalanced say annually, mirrors the underlying 1X ETF very closely. In fact it is a bit better on a risk adjusted basis. Blue portfolio: 100% SPY (an S&P 500 index ETF) Red portfolio: 50% SHV (short-term U.S. bonds), 50% SSO (a 2X leveraged S&P 500 ETF) These two portfolios gave nearly identical returns from 2008 to the present. I found this to be contradictory to everything I read about leveraged ETFs. A six year back-test should be enough to unveil the presumed decay, but I don't see it. I am particularly interested in this way of investing as it provides a way to beat SPY without taking all the risk of being all-in. If on the cash component one can earn more than what SSO pays to borrow to buy stock (these days, one can make 2.3% or so using a...

When you borrow to invest, it is called using leverage. I’ll explain the basics of leverage and then hit you with a one-question quiz to see how well you understand its effects. If you have $100,000 and borrow $100,000 more so you can invest a total of $200,000, it’s called using 2:1 leverage. If you borrowed $200,000 to invest a total of $300,000, that’s 3:1 leverage. Once you’ve leveraged your portfolio, there are two ways basic approaches to maintaining that leverage. One is to rebalance periodically so that you maintain the same level of leverage. This means that if you’re leveraged 2:1 and stocks go up, you borrow to buy more shares to maintain the 2:1 leverage. If stocks go down, you sell shares and pay off some debt to get back down to 2:1. The other basic approach is to treat the debt and investments separately, just paying the loan interest. Your leverage ratio goes up and down as your investments go down and up. If you had invested in the exchange-traded fund of ...

I was reading an article called Why borrowing to invest (leveraging) is a good idea (on a site called FinanceWorks that has since disappeared).  I’ve read many reasonable articles that point out the positive side of leverage and expected more of the same here. However, I didn’t get more of the same. The interesting part of the article begins when the authors take aim at critics of leveraging: “Critics argue that leveraging increases investment risk and that a rate of return higher than the loan’s interest rate is needed to generate a profit. But neither claim is accurate.” Okay, this is going to be good. Apparently, leverage doesn’t increase risk and you can profit even if you pay more to borrow than you make on your investments! Let’s start with risk: “Risk, as far as it pertains to investing, is the odds that you will lose money. By this definition, we have to question how borrowing money can impact risk. After all, whether you invest your own money or that of the bank...

With 5-year Canadian bonds paying about 1.2% interest, it’s hard to see how anyone could get ahead by borrowing money at 3% or more to invest in bonds. Yet this is what many people are doing, probably without realizing it. Let’s start with the example of the widow Mary whose Investors Group advisor had her borrow $50,000 to invest . Mary’s leveraged portfolio is currently invested 44% (about $22,000) in bonds. She pays 3.5% interest on her investment loan and pays a yearly management expense ratio (MER) of 1.75%. Even if we assume that the bonds will pay 2% to maturity, Mary is losing about $715 per year (pre-tax) on this part of her portfolio. Mary has about $28,000 worth of stocks in her portfolio. On these stocks she pays a blended 2.7% MER and 3.5% on the investment loan. To make up for the $715 loss requires an additional 2.55% return. Adding up these percentages, we find that the stocks must return about 8.75% just for Mary to break even for the year. One thought her...

In late 2006, Mary (not her real name), a 75-year-old widow, accepted the advice of her Investors Group advisor to borrow $50,000 to invest in mutual funds. She has maintained this loan for over 6 years now. Mary is an intelligent woman, but not an experienced investor. It’s easy to see how this move was good for Investors Group, but very hard to see how it was good for Mary. Mary’s recollection is that this strategy was somehow going to save her heirs money on taxes. The only connection to taxes that I can see is that she can write off the loan interest each year. But this just saves her a fraction of the interest; she still has had to pay the rest. The main thing this leverage did was add another $50,000 to Investors Group’s assets under management. As of the end of 2012, this figure has shrunk a little to about $49,800. The hidden management expense ratio (MER) cost on these assets is $1211 per year. After accounting for the tax write-off for interest, Mary has lost $91...

A recent request to advertise on this blog came from a company I won’t name, but their web site’s home page contains a prominent risk warning about their leveraged spread products. Part of the warning says “losses can quickly exceed your initial deposit” and “not suitable for all customers.” This should scare people away, but I wonder if it draws some people in. Repeated warnings of adult content in television shows seem to be more a form of bragging than warning. I’m sure there are parents who use these warnings to find tame content for their children, but more often these warnings draw viewers in. On a certain level the risk warning on the web site was saying that the investment products are only for sophisticated investors who know what they are doing. That can be like telling a teenager not to try smoking if he’s chicken. I’m willing to bet that most of this company’s clients are men.

Reader JP sent some questions about his leveraged investments and whether he should hold his mortgage in his RRSP. Here is an edited version of his questions: “Does it make sense to hold my residential mortgage in my RRSP? Given the size of my RRSP and the modest remaining size of my mortgage, I’m really torn about what steps to take. In addition to my RRSP I have after tax investments that I purchased using a secured line of credit, separate from the mortgage, and I claim the interest as investment costs. On one hand, I have enough that I could simply blow away the mortgage by cashing out the after tax investments. The after tax investments give a nice stream of dividends, but does it make sense to have them and still have the mortgage sitting there? Do RRSP contributions make any sense now that my wife and I are now both ‘employees’ rather than ‘contractors’ and we still have the mortgage sitting there?” To start with, I have nowhere near enough information to give JP any spe...

In the book Lifecycle Investing , authors Ian Ayres and Barry Nalebuff propose an investing strategy for diversifying across time that involves all-stock investing with 2:1 leverage while you are young. Many readers would be tempted to quickly dismiss this idea as crazy, but the authors are not crazy and they do a good job of answering (almost) all objections. Common advice is to think about all of your savings together as a single portfolio. Even if you have multiple accounts, your focus should be on having a sensible overall asset allocation; the allocation within any one account is less important. Ayres and Nalebuff take this a step further to say that you should take into account future savings as well. So, if you are destined to save $200,000 over the course of your lifetime, and a 50/50 split between stocks and bonds suits you, then ideally you should have $100,000 worth of exposure to stocks and $100,000 exposure to bonds for your entire life. If we treat your future sav...

Big economic events, popularized as “black swans”, are known to happen more often than standard economic theory predicts . However, it’s not easy for most investors to figure out what they should do with this information other than to be vaguely worried. One important implication is that leverage is more dangerous than it appears. Leverage just means borrowing to invest. If you invest $50,000 and it goes up 10%, you make $5000. But if you had borrowed another $50,000 at 4% interest, you’d have made $10,000 less $2000 in interest for a profit of $8000. When investments are rising, leverage is a wonderful thing. However, when investments are dropping, leverage magnifies losses. There is even the possibility of going completely broke if the value of your investments drops below the amount you owe. In most cases where investors use leverage, they can weather minor storms by paying off the leverage loan with employment income. This way they can wait out stock market tumbles unti...

Canadian Couch Potato took a detailed look at whether leveraged ETFs can cause market instability including links to other opinions on the subject. Missing in the various articles I read was a clear and simple explanation of the forces that can cause leveraged ETFs to add to market volatility. 2X Bull ETF Consider first an ETF that seeks to give double the daily return of a given stock index. Suppose that investors have invested a total of $100 million. There are many ways for an ETF to gain double exposure, but we'll look at a simple method: the ETF borrows another $100 million and buys $200 million worth of index stocks. At the start of the day the ETF holdings are Stock: $200M Cash: -$100M The ETF's goal is to maintain a 2:1 ratio between stocks and borrowed cash. Let's now look at what happens on a volatile day. If stocks go up 5%, the holdings are now Stock: $210M Cash: -$100M At the end of the day, the ETF has to borrow another $10 million to b...

Leveraged ETFs are designed to return double or triple the return of an index each day, but they come with disclaimers warning that they won’t double or triple returns over longer periods of time due to a mysterious compounding effect. I’ve come up with a more concrete explanation that is hopefully more understandable. An example of a leveraged ETF is the Horizons BetaPro S&P/TSX 60 Bull ETF (ticker: HXU). If the TSX 60 goes up 1% on a given day, HXU goes up 2%. The confusing part is that if the TSX 60 goes up 10% in a year, HXU doesn’t go up 20% that year. A partial reason is the management fees charged to run HXD, but this doesn’t fully explain the seemingly missing returns. To understand what is going on, imagine a volatile 2 days where the TSX 60 goes up 10% then goes down 10%. Let’s track a $100 investment in the TSX 60 for the 2 days: TSX 60: Start: $100, after up day: $110, after down day: $99 So, by the magic of compounding we lost a dollar. Here is the unsat...

Most of us have thought at one time or another that we’d like to use what we know now to go back in time and make different choices. Looking back at stock prices in 2009, it’s clear that a big bet on stocks in March would have paid off handsomely. In a discussion of leverage in November 2008, I came dangerously close to making a prediction: “Let me reiterate that I’m not a fan of leverage, but if there ever is an appropriate time for it, now is probably that time.” As it turns out, stocks dropped further, but are now significantly above the level on that day. Suppose that I had borrowed $250,000 against my house to invest in the TSX Composite index, which was sitting at 9424.00 that day. The lows in March would have produced a painful paper loss of nearly 20%, but I’d be ahead 24.7% as of the closing value of 11,754.61 on Christmas Eve. Assuming that I paid about $10,000 in interest on the mortgage, my net gains right now would be $51,800. That’s not a bad payoff for minima...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. The second financial advisor I actually invested money with was a pleasant woman who used to work at my bank branch handling my mortgage and had moved out on her own. I won’t use her real name; let’s call her Gina. Initially, my wife and I each invested a small sum with Gina in some mutual funds. We were contemplating moving the rest of our investments over from our first financial advisor, but Gina had an idea for something even bigger. The Pitch Based on our income and lack of debt, Gina said that we should be borrowing a large sum of money and investing it. Interest rates were low, and when it came to taxes the interest could be deducted from the big gains we were sure to make on our investments. At the end of 5 years, we would have big profits with “no money down”. Gina worked on us for quite a while with this pitch. Fortunately, the borrowing ma...

A reader, PR, asked the following question: “I am moving in a few months and I'm trying to work out whether it will be wiser to buy a house outright (I can do so with savings from my last house, sold in 2006) or incur a mortgage. I have read Ric Edelman's spiel about why it is always better to take a mortgage instead of pay outright. I can see why it would work out if I were planning to stay, but I know I will be selling the house in 3 years. What do you think?” The first thing to realize is that whether you have a mortgage or not, you are exposed to the full volatility of the value of your house. The bank that gives you a mortgage isn’t your partner in your home investment. If your home’s value drops, the bank will still want all of their money back. If you decide to take a mortgage, then your portfolio will consist of your house plus the investments you make with the money you have on the side. You would be using leverage to increase the size of any portfolio gains...

Before the recent financial crisis, hedge funds were generally known as mysterious investments that make outsized returns. Now they have a reputation for flaming out. The reason why so many hedge funds have failed is easier to understand once we see that hedge fund managers maximize their expected returns by taking more chances than are good for investors. The main differences between hedge funds and regular mutual funds are Types of investments. Hedge funds are less closely regulated and tend to make riskier investments than mutual funds make, such as shorting stocks and using leverage. Fees. In addition to a yearly management fee, hedge funds charge a performance fee, which is a percentage of any returns over a certain threshold. A “2 and 20” hedge fund would charge 2% of the full amount invested plus 20% of all returns above the threshold. The performance fee is supposed to align the interests of the money manager and the investors, but it does this quite poorly. On...

In his book Money for Nothing and Your Stocks for Free , author Derek Foster offers two strategies for boosting investment returns: selling put options and leveraging your house. Let’s examine these strategies. 1. Selling Put Options Foster suggests finding a good dividend-paying stock that you’d like to own. However, instead of just buying the stock, he wants you to sell put options on the stock. How this works is best explained with an example. I’ll use some actual (approximate) figures for Royal Bank stock (ticker: RY). Let’s say you’d like to own 200 shares of RY that are currently trading for about $46 each. You could just buy the stock for about $9200 right now, or you could sell put options on 200 shares. Royal Bank December put options at $44 have a premium of about $3.50. This means that someone is willing to pay you $3.50 for the option to sell you a share of RY for $44 any time between now and the third Friday in December. Based on 200 shares, you can collect ...