I haven’t done a deep dive on this but I think futures are better than this analysis makes them look.
Suppose that I’m in the top bracket and pay 23% taxes on futures, and that my ideal position is 2x SPY.
In a tax-free account I could buy SPY and 1x SPY futures, to get (2x SPY − 1x interest).
In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years. This has a small problem and a bigger problem:
Small problem: it may be some years before I can use up those taxable losses. So I’ll effectively pay interest on the money over those years. If real rates were 2% and I had to wait 5 years on average to return to my high-water mark, then this would be an effective tax rate of (2% * 5 years) * (23%) ~ 2.3%. I think that’s conservative, and this is mostly negligible.
Large problem: if the market goes down enough, I could be left totally broke, and my taxable losses won’t do me any good. In particular, if the market went down 52%, then my 2x leveraged portfolio should be down to around 23% of my original net worth, but that will entirely be in the form of taxable losses (losing $100 is like getting a $23 grant, to be redeemed only once I’ve made enough taxable gains).
So I can’t just treat my taxable losses as wealth for the purpose of computing leverage. I don’t know exactly what the right strategy is, it’s probably quite complicated.
The simplest solution is to just ignore them when setting my desired level of leverage. If you do that, and are careful about rebalancing, it seems like you shouldn’t lose very much to taxes in log-expectation (e.g. if the market is down 50%, I think you’d end up with about half of your desired leverage, which is similar to a 25% tax rate). But I’d like to work it out, since other than this futures seem appealing.
In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years.
This is a really interesting and counterintuitive idea, that I really like, but after thinking about it a lot, decided probably does not work. Here’s my argument. For simplicity let’s assume that I know for sure I’m going to die in 30 years[1] and I’m planning to donate my investment to a tax-exempt org at that point, and ignore dividends[2]. First, the reason I’m able to get a better expected return buying stocks instead of a 30-year government bond is that the market is compensating me for the risk that stocks will be worth less than the 30-year government bond at the end of 30 years. If that happens, I’m left with 0.3x more losses by buying 1.3x futures instead of 1x stock, but the tax offset I incurred is worth nothing because they go away when I die so they don’t compensate me for the extra losses. (I don’t think there’s a way to transfer them to another person or entity?) So (compared to leveraged buy-and-hold) the futures strategy gives you equal gains if stocks do better than risk free return, but is 0.3x worse if stocks do worse than risk free return. Therefore leveraged buy-and-hold does seem to represent a significant free lunch (ultimately coming out of government pockets) compared to futures.
ETA: The situation is actually worse than this because there’s a significant risk that during the 30 years the market first rises and then falls, so I end up paying taxes on capital gains during the rise, that later become taxable losses that become worthless when I die.
ETA2: To summarize/restate this in a perhaps more intuitive way, comparing 1x stocks with 1x futures, over the whole investment period stocks give you .3x more upside potential and the same or lower downside risk.
[1] Are you perhaps assuming that you’ll almost certainly live much longer than that?
[2] Re: dividends, my understanding is that equity futures are a pure bet on stock prices and ignore dividends, but buying ETFs obviously does give you dividends, so (aside from taxes) equity futures actually represent a different risk/return profile compared to buying index ETFs. I’m not sure how to think about this, e.g., can we still treat SPY and SPX futures as nearly identical (aside from taxes), and which is a better idea overall if we do take both dividends and taxes into account?
I haven’t done a deep dive on this but I think futures are better than this analysis makes them look.
Suppose that I’m in the top bracket and pay 23% taxes on futures, and that my ideal position is 2x SPY.
In a tax-free account I could buy SPY and 1x SPY futures, to get (2x SPY − 1x interest).
In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years. This has a small problem and a bigger problem:
Small problem: it may be some years before I can use up those taxable losses. So I’ll effectively pay interest on the money over those years. If real rates were 2% and I had to wait 5 years on average to return to my high-water mark, then this would be an effective tax rate of (2% * 5 years) * (23%) ~ 2.3%. I think that’s conservative, and this is mostly negligible.
Large problem: if the market goes down enough, I could be left totally broke, and my taxable losses won’t do me any good. In particular, if the market went down 52%, then my 2x leveraged portfolio should be down to around 23% of my original net worth, but that will entirely be in the form of taxable losses (losing $100 is like getting a $23 grant, to be redeemed only once I’ve made enough taxable gains).
So I can’t just treat my taxable losses as wealth for the purpose of computing leverage. I don’t know exactly what the right strategy is, it’s probably quite complicated.
The simplest solution is to just ignore them when setting my desired level of leverage. If you do that, and are careful about rebalancing, it seems like you shouldn’t lose very much to taxes in log-expectation (e.g. if the market is down 50%, I think you’d end up with about half of your desired leverage, which is similar to a 25% tax rate). But I’d like to work it out, since other than this futures seem appealing.
This is a really interesting and counterintuitive idea, that I really like, but after thinking about it a lot, decided probably does not work. Here’s my argument. For simplicity let’s assume that I know for sure I’m going to die in 30 years[1] and I’m planning to donate my investment to a tax-exempt org at that point, and ignore dividends[2]. First, the reason I’m able to get a better expected return buying stocks instead of a 30-year government bond is that the market is compensating me for the risk that stocks will be worth less than the 30-year government bond at the end of 30 years. If that happens, I’m left with 0.3x more losses by buying 1.3x futures instead of 1x stock, but the tax offset I incurred is worth nothing because they go away when I die so they don’t compensate me for the extra losses. (I don’t think there’s a way to transfer them to another person or entity?) So (compared to leveraged buy-and-hold) the futures strategy gives you equal gains if stocks do better than risk free return, but is 0.3x worse if stocks do worse than risk free return. Therefore leveraged buy-and-hold does seem to represent a significant free lunch (ultimately coming out of government pockets) compared to futures.
ETA: The situation is actually worse than this because there’s a significant risk that during the 30 years the market first rises and then falls, so I end up paying taxes on capital gains during the rise, that later become taxable losses that become worthless when I die.
ETA2: To summarize/restate this in a perhaps more intuitive way, comparing 1x stocks with 1x futures, over the whole investment period stocks give you .3x more upside potential and the same or lower downside risk.
[1] Are you perhaps assuming that you’ll almost certainly live much longer than that?
[2] Re: dividends, my understanding is that equity futures are a pure bet on stock prices and ignore dividends, but buying ETFs obviously does give you dividends, so (aside from taxes) equity futures actually represent a different risk/return profile compared to buying index ETFs. I’m not sure how to think about this, e.g., can we still treat SPY and SPX futures as nearly identical (aside from taxes), and which is a better idea overall if we do take both dividends and taxes into account?