My daughter is a millionaire

[Jeff W]

Barron,

Supposing the strategy is technically sound:

Can this strategy be implemented in Taxable accounts? You have the taxes on the Treasuries gouging your returns mercilessly.

If not, can it be implemented in an IRA account? I'd think that IRAs would restrict one from leveraging.

[DcifrThs]

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Barron,

Supposing the strategy is technically sound:

Can this strategy be implemented in Taxable accounts? You have the taxes on the Treasuries gouging your returns mercilessly.

If not, can it be implemented in an IRA account? I'd think that IRAs would restrict one from leveraging.

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i have to admit i don't understand your question [img]/images/graemlins/confused.gif[/img]

can you rephrase or explain?

Thanks,
Barron

[Jeff W]

I might just be missing how the transactions work... bond repo, etc, way out of my depth.

At some point in the chain, you're buying treasuries, right? And the income from the bonds is taxed... doesn't that kill your returns and make it unfeasible to implement this in a taxable account?

Second part I guess would be to ask whether you can complete the necessary transactions in a retail investor's IRA account.

[DcifrThs]

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I might just be missing how the transactions work... bond repo, etc, way out of my depth.

At some point in the chain, you're buying treasuries, right? And the income from the bonds is taxed... doesn't that kill your returns and make it unfeasible to implement this in a taxable account?

Second part I guess would be to ask whether you can complete the necessary transactions in a retail investor's IRA account.

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i wasn't clear, my bad.

my stance on the OPTIMAL allocations is what i summarized in this thread.

you can come pretty close though without the hassles. instead of leverage, just allocate more to bonds and less to equities giving the bonds more share in risk space.

invest in funds that reinvest dividends so (i think) that you don't get taxed until you sell shares of the fund.

you can come close to optimal without having to do repos yourself...but you can if you want. interactive brokers is the way to go for the more active.

otherwise, adjusting allocations will cost you slightly in returns but increase your overall performance significantly.

Barron

[Jeff W]

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invest in funds that reinvest dividends so (i think) that you don't get taxed until you sell shares of the fund.

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I believe you get taxed on those dividends.

[Nomad84]

Barron, I am very interested in the concepts you have described. While I don't yet understand the details of obtaining the leverage, I plan to do more research to learn about it. In particular, I'm not clear on how the costs of obtaining leverage will affect the outcome, however I think you mentioned that the risk free rate is a good approximation of the repo. I'll be reading plenty more on this topic because I believe that it truly is as good a strategy as you make it out to be.

Here is my take on it. It seems to me that the primary goal of diversification should be to find uncorrelated or negatively correlated assets in order to reduce portfolio volatility, NOT to simply mix in lower volatility assets to reduce portfolio volatility. The problem is that these assets have different risk/return characteristics. My understanding of the strategy you've been discussing is that it helps to approximately equalize risk between asset classes by using leverage with the lower risk assets (which also results in similar returns between asset classes), so that you can effectively manage the portfolio based more on the correlation between assets and less on the risk profiles of the particular assets. The result should be a portfolio with roughly the same returns as a 100% stock portfolio (or whatever you are using as the "benchmark" risk), but with lower volatility due to the lack of correlation between the assets. Similarly, it seems that you could design a portfolio with similar risk to 100% stocks using these ideas, and obtain a higher expected return. Obviously, if those two sentences are correct, you could also find a middle ground with less risk and more return than stocks. Do I have the basics concepts right? I'm particularly curious as to whether my statement about how to "correctly" diversify is correct. Thanks!

BTW, while searching for more info on repos, I found this link. I found it interesting even though I didn't fully understand it. The first half did a good job of explaining to me how repos work. Others who are learning about repos may also find it worth reading.

[technologic]

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invest in funds that reinvest dividends so (i think) that you don't get taxed until you sell shares of the fund.

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I believe you get taxed on those dividends.

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aren't all dividends considered regular incomes in addition to interest payments?

[edtost]

[ QUOTE ]
Here is my take on it. It seems to me that the primary goal of diversification should be to find uncorrelated or negatively correlated assets in order to reduce portfolio volatility, NOT to simply mix in lower volatility assets to reduce portfolio volatility. The problem is that these assets have different risk/return characteristics. My understanding of the strategy you've been discussing is that it helps to approximately equalize risk between asset classes by using leverage with the lower risk assets (which also results in similar returns between asset classes), so that you can effectively manage the portfolio based more on the correlation between assets and less on the risk profiles of the particular assets. The result should be a portfolio with roughly the same returns as a 100% stock portfolio (or whatever you are using as the "benchmark" risk), but with lower volatility due to the lack of correlation between the assets. Similarly, it seems that you could design a portfolio with similar risk to 100% stocks using these ideas, and obtain a higher expected return. Obviously, if those two sentences are correct, you could also find a middle ground with less risk and more return than stocks. Do I have the basics concepts right? I'm particularly curious as to whether my statement about how to "correctly" diversify is correct. Thanks!

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This is the same way I interpret Barron's opinion, and demonstrates a good understanding of diversification benefits. The hard part, then, is determining the correct "benchmark" risk. If you're benchmark risk is equal to or above all the volatilities of your individual assets, you'll be levering things up to maximize return. If its lower, though, you'll wind up "levering down" by making, say, your 40% US equity allocation actually 30% US equities and 10% risk-free bonds. In reality, this would be accomplished by repo-ing less bonds for those assets you do have to lever up rather than taking both long and short risk-free bets that wind up offsetting. At some point, the "benchmark" variance will be such that the optimal portfolio using this method has net zero leverage, (that is to say, the long and short risk-free assets used to lever other allocations up or down cancel each other out and are not needed at all), which should give the same result as a standard portfolio optimization model that doesn't consider leverage.

[DesertCat]

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invest in funds that reinvest dividends so (i think) that you don't get taxed until you sell shares of the fund.

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I believe you get taxed on those dividends.

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aren't all dividends considered regular incomes in addition to interest payments?

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Most U.S. dividends are given special treatment now and taxed at 15%, same as long term capital gains. There are exceptions, as usual.

[Nomad84]

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Here is my take on it. It seems to me that the primary goal of diversification should be to find uncorrelated or negatively correlated assets in order to reduce portfolio volatility, NOT to simply mix in lower volatility assets to reduce portfolio volatility. The problem is that these assets have different risk/return characteristics. My understanding of the strategy you've been discussing is that it helps to approximately equalize risk between asset classes by using leverage with the lower risk assets (which also results in similar returns between asset classes), so that you can effectively manage the portfolio based more on the correlation between assets and less on the risk profiles of the particular assets. The result should be a portfolio with roughly the same returns as a 100% stock portfolio (or whatever you are using as the "benchmark" risk), but with lower volatility due to the lack of correlation between the assets. Similarly, it seems that you could design a portfolio with similar risk to 100% stocks using these ideas, and obtain a higher expected return. Obviously, if those two sentences are correct, you could also find a middle ground with less risk and more return than stocks. Do I have the basics concepts right? I'm particularly curious as to whether my statement about how to "correctly" diversify is correct. Thanks!

[/ QUOTE ]

This is the same way I interpret Barron's opinion, and demonstrates a good understanding of diversification benefits. The hard part, then, is determining the correct "benchmark" risk. If you're benchmark risk is equal to or above all the volatilities of your individual assets, you'll be levering things up to maximize return. If its lower, though, you'll wind up "levering down" by making, say, your 40% US equity allocation actually 30% US equities and 10% risk-free bonds. In reality, this would be accomplished by repo-ing less bonds for those assets you do have to lever up rather than taking both long and short risk-free bets that wind up offsetting. At some point, the "benchmark" variance will be such that the optimal portfolio using this method has net zero leverage, (that is to say, the long and short risk-free assets used to lever other allocations up or down cancel each other out and are not needed at all), which should give the same result as a standard portfolio optimization model that doesn't consider leverage.

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I hadn't considered that, but it makes sense. Still, for someone like me who is only 23 years old and currently willing to accept the risk inherent in the the S&P500, for example (meaning I wouldn't be too risk averse to put everything in an S&P500 index fund), it seems that I could put these ideas to work to achieve an S&P-beating return with the same volatility. When viewed in the context of your statements, it seems logical that the way to achieve this would be to take the optimal non-leveraged portfolio and essentially leverage everything equally to achieve the desired level of risk. I had always listened to the standard advice of don't invest on margin and pretty much just took it at face value, but now that I understand things better, I feel like using leverage may not be as irresponsible as many (well-meaning) folks seem to think. It will just require a good understanding of my true portfolio risk levels and my risk tolerance. Also, I find it interesting that it is possible to lever an entire portfolio at least to a small degree by repoing bonds (and possibly other assets?) rather than using the traditional margin account. If I'm understanding what I've been reading, the repo rate is quite a bit less than the rates charged to borrow in a normal margin account. Obviously borrowing at above the risk-free rate will decrease your risk-adjusted performance since you are taking on additional risk in order to achieve proportionally less additional gains (due to the cost - above the risk free rate - of borrowing money). Repo rates that are approximately equal to the risk free rate don't create this negative impact.

I am still not clear on how to weight everything based on how the various assets correlate, but that doesn't really seem to be the topic of discussion, so I'll save that for another thread. Besides, I don't really know enough about that to ask any intelligent questions right now.