Leverage and its Danger

First of all, I would like to state that I’m not against leverage per se. Leverage has its usefulness. For example, families borrow money to buy their dream home; without leverage, they would have to wait decades in order to do it. Companies use leverage to obtain working capital, expand into new arena and as start-up capital. Leverage is also used extensively by banks to take in deposits and loan out money. Without leverage, there would be many lost business opportunities and the economy would not have the lubricant to function as well as it does.

That being said, however, leverage in investments in stocks and shares by individual investors has questionable value. Very often, individual investors obtain capital by taking a loan and invest the proceeds with the expectation of obtaining a higher than average return. Some open a margin account with a local brokerage at high margin rates while others dabble in derivatives or instruments such as leverage ETF or banks’ structured products. Those who have the misfortune to invest in such products usually have poor results. Some instruments such as futures and options can even get you wiped out within days! The peril of leverage could not be more understated.

The problem with leverage investments is that the loan you obtained most likely needs to be collateralized. High tide raises all boats and when the going is good, financial institutions rush to provide you with liquidity but when things got tough, you’ve to repay part of your loan to maintain the gearing ratio. If you cannot repay, the financial institutions will perform margin selling of your collateral to obtain capital. This is the crux of the matter – you as the investor have to sell off your assets at your low point and are not given more time to wait for the inevitable recovery to come. When the eventual recovery does come, you’re now asset light again and miss out on the good opportunity. This results in the frequently quoted adage that it takes a 100% gain to recovery from a 50% loss. The phenomenon is also known as volatility drag. As you can see, the short term nature of the debt we as individual investor can obtain is greatly to our disadvantage.

To further exacerbate the matter, some financial institutions charge a 5% to 10% interest rate on the loan. This is pretty high as it covers a large portion of the expected equity premium. As a frame of comparison, the stock markets return less than 10% over the very long term. Furthermore, we’ve to account for the commissions and slippage due to the ongoing trading required by the maintenance of gearing ratios.

To make the matter clearer, I’ve back tested multiple mutual funds over periods of several years to illustrate the detriment of leverages. To simplify the matter, I assume that slippages, commissions and interests charges are zero and we simply measure the effects of leverages and volatility drag have on the mutual funds. The single-fund portfolios are formed according to the gearing ratio and rebalanced on a daily basis back to their gearing ratios as the fund prices fluctuate.

This is the result of the returns of the various mutual funds leveraged by different ratios.

Leverages Date 1x 1.5x 2x 3x
Vfinx (S&P500) ’87 to ’12 8.6% 11.6% 13.5% 13.8%
Vhdyx (High div yield) ’06 to ’12 1.6% -0.1% -3.4% -14.0%
Veiex (Emerging mkts) ’95 to ’12 8.2% 10.1% 10.6% 6.6%
Veurx (European mkts) ’90 to ’12 7.9% 10.2% 11.3% 9.7%
Visvx (USA Small-cap value) ’98 to ’12 7.2% 8.4% 8.0% 2.2%
Vgsix (USA Reit) ’96 to ’12 10.6% 12.4% 11.6% 2.1%

 

As you can see, the results are not that impressive. For all cases of leverages, you get x-times the risk but not x-times the returns. The 3x portfolios are particularly damaging to your wealth if you take into account of slippages, commissions and interest charges. Only the S&P500 portfolios have decent but not great results due to leveraging. The USA high dividend yield fund is particular abysmal in this regards. For some funds, returns improved only slightly as the leverages go up while for others, returns actually dropped (some precipitously). The greatest falls can be seen as we move from 2x to 3x leverages.

The data file used to crunch the result is available online for viewing. It is written in Excel 2007/2010 format. The source of the mutual fund prices are from Yahoo! Finance.

As you can see from the results, all individual investors alike should reconsider before taking the plunge in leveraging their portfolios. History shows that the results are not good. The best results are gotten from portfolios that have a balance of stocks and bonds. The highest equity contents a portfolio can contain should be 100% stocks.  The questionable excess returns of leverages and the horrendous equity-related risks are simply not worth it!

4 thoughts on “Leverage and its Danger”

  1. http://www2.stetson.edu/fsr/abstracts/vol_11_num1_p33.pdf
    http://www.investmentreview.com/files/2009/12/leveraged_portfolios1.pdf
    http://gosset.wharton.upenn.edu/research/retirement.pdf
    http://aima-canada.org/doc_bin/AIMA_Canada_StrategyPaper_06_Leverage.pdf

    Above are some links to research articles about leverage and investing.

    Moshe Milevksy, in “Are You A Stock Or A Bond, Benjamin Siegel in “Stocks for the Long Run” and of course, Ayres and Nalebuff in “Lifecycle Investing” are supportive of leverage.

    A major problem with leverage is the rebalancing. When one rebalances between stocks and bonds, results tend to improve, as one tends to buy low and sell high. Leverage is akin to negative bonds, and things work in reverse. When one rebalances between negative bonds and stocks, results are worse, as one tends to buy high and sell low. Losses that are reversible in an unlevered account can become irreversible in a levered account.

    The following is from the link below. From 1958 to 2009, the S&P500 was up 53% of days and down 47% of days; for months, 58% up and 42% down; for quarters, 63% up and 37% down; for years 72% up and 28% down; for 5 year rolling time periods, 76% up and 24% down; for 10 year rolling time periods, 88% up and 12% down. The above data ignore the impact of reinvested dividends.

    http://moneyover55.about.com/od/howtoinvest/a/bearmarkets.htm

    So in the daily rebalancing of your analysis, you will be buying high 53% of the time and selling low 47% of the time. That won’t work well in the long term.

    http://islandia.law.yale.edu/ayers/DiversifyingAcrossTime.pdf

    About the concern of high interest rates on investment loans, that is legitimate. However, Interactive Brokers offers margin loans that are very competitive. The above link shows that Interactive was offering margin loans that were at most 1.55% above the 91 day US Treasury bill rate. For margin loans greater than $100,000, the rate was 1.05% above the 91 day US Treasury bill rate.

    I am in no way making a blanket endorsement of leverage. Many (most?) people should not use leverage. Anyone considering the use of leverage should think about it long and carefully. But in my opinion, for the appropriate investor, it is a reasonable option to consider.

  2. Hi Park,

    Prof Siegel is an eternal optimist, but I don’t recall he proposed investors leverage their accounts in his book.

    Mosche is the one who recommended young investors leverage in stocks and he eats his own pudding. If you google the web, there are news of his portfolio getting decimated during the financial crisis. It’s important not to engage in imprudent financial affairs such that your portfolio suffers from permanent irrecoverable losses.

    Also, you need to rebalance when stocks go up to maintain risk exposure. When stocks go down, you need to sell to meet margin calls.

    1. Stocks for the Long Run, Jeremy Siegel, 2008 edition, page 34

      Professor Siegel recommends the use of leverage for moderate risk takers with a 30 year holding period; he recommends it for aggressive risk takers with a 10 or 30 year holding period.

      I agree that one should avoid permanent irreversible losses. And margin calls will result in that. If one is going to use a margin loan for leverage, it should be well thought out and no more than moderate leverage should be used.

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