Leveraged investing means more potential return and more risk. Using leverage presents an opportunity to make bigger returns but also amplifies losses. In short, borrowing money to increase the power of your investible funds is a doubled‐edged sword.
A leveraged investment has a beginning amount of equity and a given amount of debt, which determines the leverage ratio.
An investor with £5,000 in equity could decide to borrow £10,000 to give themselves three times leverage – providing them with a total of £15,000 of investible funds.
The leverage ratio is the biggest factor in determining the percentage gain or loss in the £5,000 of equity for a given change in the underlying investment.
For instance, if the £15,000 is invested in the FTSE All Share Index then a 15% gain in the UK stock market could theoretically equate to a 45% gain in equity.
However, to calculate the profit from the position, we need to consider the cost of borrowing, which depends on the interest rate and the length of time the position is held. The higher the cost of borrowing, the lower our actual profit.
Assuming the cost of our borrowing in percentage terms over the given time period is 4%, then the profit from the position would be:
(£15,000 × 15%) − (£10,000 × 4%) = £1,850
In this example, the use of leverage has enabled us to grow our £5,000 equity to £6,850. Had we not used any leverage, the initial £5,000 would have grown to £5,750. Using leverage has thus netted an additional £1,100.
The problem comes when we experience a sharp sell‐off in the market. Imagine that over the same period there is instead a stock market crash, with the FTSE All Share falling by 45%.
The loss from our position is:
(£15,000 × 45%) + (£10,000 × 4%) = £7,150
In this example, our initial £5,000 has been more than wiped out, leaving our investment in negative equity or ‘underwater’.
If we can hold on to the position in the hope that stock market recovery could see us recoup our losses, and even enter profitability, we still need to pay interest on the £10,000 of borrowed funds, despite the shares being worth only £8,250.
This is a major problem as interest compounds over time; the longer we have to wait for recovery, the more the interest on the borrowed funds will eat into any counteracting positive impact from a recovery in the stock market.
An exchange-traded fund (ETF) is an investment fund quoted on the stock market that typically tracks a given index.
Over recent years there has been a significant increase in the number of leveraged ETFs, enabling investors to amplify returns from popular indexes, typically with a 2:1 or 3:1 ratio.
Other types of margin buying tend to be more expensive once the implicit costs of borrowing are considered.
Leveraged ETFs are available to allow investors to profit from rising and falling markets, amplifying the returns from conventional ETFs according to the fund’s given leverage ratio.
Such vehicles are often used by investors to take short-term positions, typically lasting just a few days.
Rather than amplifying the returns from a given index’s annual returns, leveraged ETFs reflect daily changes. The impact of daily repricing and volatility means leveraged ETFs can diverge significantly from their underlying indexes.
An investor who puts £10,000 in a long‐leveraged ETF with 3:1 leverage, where the underlying index falls 5% on the first day and rises 5% on the following day, is left with £9,925 in equity on the beginning of the third day.
The conventional straight investor in the underlying index would be left with £9,975 (excluding fund charges).
Volatility can therefore be a problem for leveraged investing, especially in the short-term – investors could be wiser to consider leverage more as part of a long-term strategy.
Controversy – leverage linked to Wall Street crash
Infamously, leveraged investing was in popular use during the 1920s in the run-up to the Wall Street crash, when it was often used in a reckless way, with scant attention to risk.
Leveraged investing remains a source of controversy, with some arguing that private investors should steer well clear given the amplification of risk. Others point to the merits of enabling people to increase the power of what could otherwise be a feeble level of investible funds.
Young and old
In general terms, it is accepted that people should reduce their investment risk as they get older. Certain academics have gone further, claiming younger people can achieve better diversification over time by using leverage.
They recommend people buy stocks on margin when young but adopt a more cautious approach to investment later (see paper by professors Ian Ayres and Barry J. Nalebuff, June 2008).
Some have even pioneered the use of leverage for our twilight years. The Floor-Leverage Rule for Retirement calls for retirees to put 15% of their funds in ETFs offering 3:1 leveraged exposure to equities (see article in Financial Analysts Journal by Jason S. Scott and John G. Watson, September 2013).
While these approaches differ considerably, they both espouse leveraged investing as a long‐term strategy, combining it in some measure with conventional investing.
To leverage or not to leverage
With equities statistically more likely to rise than fall over the long term, those who can ride out the troughs of the market should theoretically be able to enhance their returns through long‐leveraged investments that compound positively over time.
For instance, a typical long ETF with three times leverage to the S&P 500 Index has generated an average annual return of 38% over five years versus an average annual index return of 14% (ProShares UltraPro S&P 500, as at 28/02/2017).
Bull and bear markets
No one can say for sure when the top of a bull market or the bottom of a bear market has been reached, but it appears counterintuitive for investors to seek even greater risk through long leverage when the market is already hitting record highs.
Exuberance can lead investors to take riskier positions at such times, but perhaps it would make more sense to wait until we have a decent sell-off before considering a long-leveraged stance.
While many investors turn to leverage investing for short-term, tactical purposes, the impact of daily repricing and volatility means such funds are better deployed as part of longer-term strategies, which could also incorporate conventional investing.