This is more about personal finance. Just like how companies think about how to optimize their financing – we should always strive for optimizing our own capital structure – essentially how we fund our day-to-day activities and finance our investments.
As an active investor / capital allocator, it is more important than ever to think about how I am financing my investments. I recently found out that I can take out a loan from my own 401K, gave more thought to it, and came to a conclusion that it makes a ton of sense to take out 401K loan under my circumstances. Read below for my situation that makes 401K an optimal financing solution and the rationale behind it.
MY SITUATION
Stable and growing cash flow: I have a stable job in a defensible industry that is largely uncorrelated to macro-economic event. This translates to a stable, predictably growing stable cash flow that can be relied on for taking on more leverage and investing with long-term time horizon. When I worked at a hedge fund (particularly most recent one), I knew my job security is highly correlated to the macro-economic dislocations – people got fired for two to three months of bad performance (nobody sees this coming as nobody expects to have bad months).
Aggressive investment portfolio: my entire investment portfolio is leveraged. Real estate obviously comes with high leverage, but it does come with very affordable interest rate (thank you for QE). I also invest in high growth stocks with leverage – that is I finance my equity portfolio with approximately 15-20% of margin at a given time. This idea is just exactly the same as what private equity fund do (I call these funds “levered equities with no mark-to-market obligation” funds). Levered equities always outperform in the long-run and you just need to stay solvent. However, stock margin loans are expensive – I use Fidelity and they charge 8% interest rate. Any way to lower the cost of margin financing would be upside.
I only have access to mutual fund products, most of which are horrible investment products: All hedge fund analysts and PMs know this that most investing public does not – mutual funds is where you go to chill and wait for retirement NOT where you work hard. This is most of the reason when many hedge fund analysts transitions to mutual funds – they are burned out / want work-life balance, but still want to get paid good paycheck. Naturally, this leads to portfolio construction that optimizes for asset preservation (for job security) rather than outperformance. This is why most mutual funds are just closet indexers – they say they are “picking stocks:, but they just try to mimic S&P as much as possible so that they minimize their tracking error. However, they charge 1-2% management fees and trade extensively throughout the year to spread fees across brokers that provide them services (client dinners, sports events, management dinners, etc.). This has enormous amount of annually recurring negative carry just to start with. So why would I waste my good money so other people can just chill and relax adding no value? Unfortunately, my plan does not allow investing in single stocks.
HOW 401K LOAN CAN SAVE ME MONEY (AND YOU TOO!)
Savings now: 401K loan is very interesting – you are borrowing from your contributed 401K and you are paying interest (4.5% for my case) to yourself! It is essentially free loan from your retirement bank! In reality, I am just using my 401K loan to pay off stock margin loan. Stock margin loan charges 8% and if I replace the margin loan with my 401K loan, I am just saving 8% right off the bat! The 401K loan interest payment is conveniently deducted from my post-tax income in my bi-weekly paycheck.
I avoid negative carry in mutual funds: in the above section, I noted investing in mutual funds is generally throwing away good money at bad. Paying 1-2% management fee plus other administration expenses for investment management that largely reflects S&P is just waste of money. 1-2% management fee annually really eats into P&L especially when compounded over time. When you take a loan, you are effectively taking money out of those mutual funds. Therefore, now I am now saving a total of 10% = 8% (from avoided margin interest expense) + 2% (management fees of mutual funds that I no longer need to pay).
I can generate excess return above most mutual funds: my portfolio construction can be done in more concentrated way – when I am creating my portfolio, I am not solving for my job security – I am just trying to make as much as I can. There is a saying “diversification preserves wealth and concentration creates wealth”. I have outperformed most of mutual funds and with levered equity portfolio with no negative carry (management fees or other wasteful admin fees), I am VERY confident that I will outperform most of mutual funds. I know this because I am familiar with investment industry and have generated very strong return in my professional career (15%+ annualized in a beta/market neutral portfolio at a multi-manager shop).
IT IS NEVER TOO LATE
As someone is mid-30s, I think I have enough lifetime left to be aggressively investing in growth with (hopefully!) many decades left for the portfolio to compound over time. Time and time again, it has been proven that stock markets go up over longer-time because our financial system is designed to depreciate fiat currency.
Taking on leverage does introduce more risk in that it adds to the volatility in your “equity” value, but as an investor, your number one priority should be maximizing cash flow when you are analyzing companies or your personal finance. And I think 401K loan could be a very efficient way to optimize your cost of capital or your WACC (weighted average cost of capital).
How do you feel about taking out a loan from 401K account? Do you think it is too risky?
*not investment advice.
