Leveraged Mutual Fund Strategies - Beware

The mortgage is finally paid off, some of the kids have left home, and there is a bit of free cash after the regular bills have been paid. How can a middle-class moppet prepare for retirement, now that it is pretty sure the Social Security net is unraveling? GIC rates have fallen, and there's so little left after taxes. Some Investment Planners have the answers and they want you to mortgage the house. Caveat Emptor.

Creative financial types have picked up on certain facts - lots of equity in homes, low interest rates, retirement concerns and ever-rising equity returns. A powerful combination results. Why doesn't everyone borrow money on the security of their home, paying low interest rates, use the proceeds to invest in the most carefully selected conservative mutual funds (to benefit from the best professional management) and experience the delights of compound interest?

The result will be retirement security, and more! Dreams of millions float readily through our exhilarated brainbox. Visions of white sand, azure seas and gently swaying palm trees tantalize our numbed defenses.

Fortunately there is still the stock market. Sure it's up somewhat, but long-term serious studies by serious academics clearly show that for patient investors, serious returns are always available. Seriously.

There is no free lunch - we know that, but where's the catch? Even if interest rates double, after writing off the interest cost, it still makes sense. Declines in the stock market are always short and sharp, scary as we're going through one, but the market always pushes through to new highs as the value of the underlying companies shines through.

Nevertheless, the nagging doubt persists. Could it be that this statistical view of history somehow distorts the realities of the financial markets? How is it that the six year decline in the stock market between 1968 and 1974, during which the broadest measure of US stock market performance declined by more than 70%, has no effect on these long-term calculations?

Some market analysts (not academic statisticians or red-suspendered risk seekers) consider that the bear market, which began in the late Sixties, did not truly end until May of 1982 with a decline of 74% after adjustment for inflation. This 16 year period was only the decline. Full recovery to the original amount required another ten years.

Be aware that a statistician can prove almost anything with a carefully selected set of numbers, over almost any time horizon. Maybe the statistician thinks that a patient long-term investor could smile for six long years at the worried banker threatening to seize the house. Or maybe bankers will never again be interested in the collateral underlying their loan.

It won't happen of course, but what if the prime interest rate currently being charged on home equity loans returned to the peak rates charged in 1981. A 20% hurdle rate would be a tough one for this high risk strategy.

It won't happen of course, but if the stock market declined for six months or a year, would falling mutual fund values and regular interest payments on the loan still feel as good? History shows that only the most patient investors have the staying power for such a strategy. Patience, remember, does not mean 6 months but rather 6 years.

Having taken a $100,000 mortgage on your house to buy a mutual fund, can you afford to see the stock market drop by 30% and have the banker come by to take the collateral on the loan back? You're $100,000 mutual fund investment has fallen to $70,000 and you are now renegotiating with the banker to save your house.

Greed and need combine, in the practice of leveraging mutual fund investments by mortgaging an asset, to demonstrate the truth of the old adage that there are "lies, damn lies and statisticians."

Article by Bob Swan - October 23, 1996

Back to The Investors' Corner

Return to The Homepage