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.
|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!