The concept of ‘Leverage’
One of the first problems that often investors face, is how to have more money to invest in a business idea, an asset or in a simple investment product like stocks, bonds or funds. Some use an investment strategy called “Leverage“.
Leverage is basically using borrowed money to have more power to buy or invest in something. Example: If someone buys a house without having the full amount, it will probably go to a bank, ask for a loan and then exchange that borrowed money plus some of his own money, for the house.
Of course the downside of this option, is that this person now has to pay for that loan, with interest. Even if something happens to the house and there is a sharply decline in its value. (Let’s leave the insurance possibility out of the picture to simplify)
Real Estate – Example
Imagine that the cost of a house is $100,000 ($100k). The investor has $20,000 in cash. Obviously this is not sufficient to buy it, so he borrows $80,000. Now this borrowed money enables the investor to invest in an asset (the house), that is far superior to the money he actually has.
Own money – $20k
Borrowed money – $80k
Total invested – $100k
From an investment perspective, this investor has leveraged his position 5 to 1 (5:1). Therefore the ratio of personal money to total invested money is $1 for every $5 invested.
Return On Investment
Here you have two options:
- Sell: If you buy for $100k, and then sell for $120k, you will have a total return of $20k (20% return). More important YOUR return on investment would have been 100%! Because after you repaid the loan (let’s ignore the interest), your return is $20k (120k – 100k). So you invested $20k, and had a return of $20k. That’s the upside of leveraging your position;
- Lease: Here you make a contract by which another person will use the house in return for a periodic payment, let’s say $500 per month. From those $500, $250 is to repay the loan plus interest. So your return would be $250 per month. That’s $3,000 per year. Thus a 3% return on the $100k investment. But the return on YOUR money, is 15%! ($3k / $20k * 100), i.e., you had a $3k return using only $20k of your own money. We are not considering important expenses such as property taxes, maintenance or insurance costs. Nonetheless you can can see the leverage effect.
Stock and Bond Market
Leverage works in a very similar way in other markets. You have a lot of options such as margin loans, future contracts, options, and so on. Just as the example of the house you can have a small amount of money, but still invest in a larger amount of stocks, bonds, funds or other financial products.
Another possibility is a leveraged exchange-traded funds (leveraged ETF). To simplify, this is a fund that uses borrowed money and other financial products such as derivatives to amplify the return of an underlying index.
This is not the same thing that I wrote in another post. On that post I wrote about plain simple and normal ETFs.
A “normal” ETF is supposed to give you the return of an index, like the S&P500, the NASDAQ100 or the Dow Jones Industrial Average. The leverage version of an ETF will try to double (or more) the return of an index on a daily basis.
Why I prefer this option:
- Simplicity. When compared with the use of futures, options or trading on margin. With leveraged ETF you issue an order in a similar way that you issue an order to buy stocks for example. Quantity, price, and type of order. And you ready to go;
- Limits the downside. So if I buy $1000 of a leveraged ETF which aims to double the return of an index, if it goes to zero, I will lose my $1k and the loss ends there. On the other hand, if I ask for a loan of $1k, and then invest a total of $2k in a simple ETF, I’m also trying to double the return, but if it goes to ZERO, I will still have to repay the loan plus interest.
The first ETF of this type was introduced by ProShares in 2006. In the beginning these ETF were supposed to double the daily return of the underlying index.
So if the S&P500 would return 2%, the leveraged ETF was supposed to return 4%.
Right now there are over 150 leveraged ETF with over $30 billion in assets under management.
Negative aspects of leveraged ETFs
There are some important and negative characteristics that an investor should consider:
- The costs are superior. When compared with a simple ETF, a leveraged ETF, could have a cost of over +1%. A simple ETF? 0.10%. Yes a leverage ETF could cost more than 10 times the simple/normal version. And that will hurt any long term return. I would definitely say that these are not suitable for long term strategies;
- High-risk investment. With leverage comes volatility. This means you can see your investment fluctuate widely in value throughout the period that you’re holding the position. Thus it could be dangerous to an uneducated investor;
- High tracking error. With all the leverage and turnover associated with this strategy, it’s very difficult for any leveraged ETF to avoid errors when trying to track the underlying index. Therefore this could dampen returns even more.
To Sum Up…
In conclusion, leverage could have a tremendous impact on your returns. It can amplify the profit, but it can also hurt a lot if your investment declines in value. Everyone should be very careful before using this strategy, and I would recommend to study really hard before even considering this option. Personally I would never borrow money to invest in the stock market. Too much risk.
This post is only for information purposes. It should not be considered financial advice or any kind of advice. Seek professional help if you need.
And you reader, do you use leverage as a strategy? Tell me about your good (and bad) experiences with leverage. Do you consider using in the future? How?