Why we deleveraged our REITs even without a margin call

This week completes the full retreat of the ERM community from their leveraged portfolios and margin accounts. This article addresses the thought processes behind the withdrawal, along with a background on our approach towards applying leverage.

Background on the use of Leverage

The Early Retirement Masterclass (ERM) is one of the rare programs that include leverage as part of investment training.

Our approach is to keep our equity multiplier to be always within x2, capping borrowed funds to about $1 for each $1 of capital injected into the margin account. Throughout the course, we emphasize that leverage is dangerous and is most appropriate by younger investors who have strong career capabilities to support a margin call. For middle-aged investors, we only employ to match a specific liability, in my case, to pay a mortgage and relieve my unleveraged portfolio.

We use only the most stable portfolios for leverage, 10-year back-tests return 12-15%, with a semivariance of around 8-11%. As such, to even lose 15%,  we need a 3-sigma event. In regular markets, this would happen 3 out of 1000 years.

As a consequence of the cautionary statements we make, in our polls, we find that less than half of the student body actively engages in margin account financing. Those that do would keep it within minimal limits, mainly as a way to understand their risk appetites.

COVID-19 as a swarm of black swans

COVID-19 changed everything we know about the markets. It did not have financial roots, so the crash could not have been detected using things like inverted yield curves and the equity risk premium.

REITs could lose 25% of their value in one day. Ironically, the ERM lecture slides did predict such an event, even though I may have failed to do so myself at a critical time.

In this COVID-19 event, quantitative strategies experienced non-stationarity the downside risk ballooned from 10% to 40+%.

The deleveraging process

I’ve been conscious that the highest point of the STI was around 3400 on April 2019. A crash indicated by the STI reaching 2380. If a 30% drop occurs, we have to throw every idea we have about the markets out of the window because historical crashes like the GFC would see a 60+% drop in the markets. It is crucial to protect the capital to live and fight another day.

I started grumbling about the markets and telling students to start deleveraging on 13 March 2020. My first sign is that the ERM portfolio has started turning negative. At that stage, with incoming dividends, I did not report a full rout until three days later on 16 March 2020. In the meantime, I had to support my portfolio when my margin account ratio hit 150%. The second time my margin account ratio hit 150% again. I started closing as many positions as possible to stop leverage completely. As I have over 40+ stock positions to liquidate, final unravelling for my portfolio occurred on 20 March 2020.

Even now, the blended ERM position would not have received an actual margin call. When I started to tell my students to run, the portfolio has lost -9.92%, magnified with leverage, it is still painful at around 23%.

Could we have done better?

We are fortunate that we have a community that is 370+ in size to provide real-time updates to our strategy. My sincere regret is that the gong of retreat should have been sound much earlier. On hindsight (which is 20-20) the optimal time to run would have been 20 January 2020 although I doubt anyone would have made that call.

I am reviewing technical indicators to see which ones hold promise to reinforce a leverage strategy.

What happens next?

While one piece of the strategy for early retirement has gone offline, another has emerged much more potent. As we speak the earnings yield of the STI is 8% higher than 20-year bond returns, even higher than during the GFC.

The period of recovery after GFC has seen returns over 15% every year with a stable volatility, but you need resilience and holding power. ERM students who unleveraged can now patiently hunt for bargains and wait for the launch of a vaccine.

The trick is to keep your margin accounts even though you are not borrowing money from your broker. Doing so can facilitate rights issues and the return of leverage when markets recover.

I will discuss the new role for a margin account in future writings, and you can play for millionaire status moving forward.