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.