Should I lever up?

There is an asymmetry to share market returns. Equity investments have unlimited upside, and limited downside. Shares can keep going up. You can only lose what you put in.

Some investors exploit this relationship between risk and return by adding leverage. Leverage is using borrowed money to potentially increase investment returns. That’s a whole different ball game and a formula that many people use in the housing market.

Say you purchase a house for $1,000,000. You put in a deposit of $200,000. Two years later you sell your home and it goes under the hammer for $1,200,000. The house has appreciated in value by 20%. However, your return on the $200,000 outlay is 100%.

This is obviously a simplistic way to calculate returns because transaction costs, interest payments, taxes, maintenance costs and principal payments have not been considered. Despite the simplicity of the example the concept stands. When leverage is used to purchase assets that appreciate the returns go up.

Leverage offers investors the potential of eye-watering returns. It is the main driver behind the success of the housing market and investors transplant the use of leverage to other asset classes. This works well in theory.

Jeffrey Ptak speaks about how academics have argued that younger professionals ought to employ leverage in the share market given their longer time horizon, higher risk capacity, and the utility of freeing up available funds for consumption.

He explains that this is good in theory, but young investors trying to meet a margin call is less than ideal. It’s a scenario that investors are usually not well equipped for, let alone being able to work through in real time. He has said, “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.”

Here’s why.

Built to be held for short periods

The issue with leverage is that it is expensive. The higher the costs of borrowing money to invest the more an investor is discouraged to focus on long-term investments.

Leveraged Investments offers variable margin loans (at 20 November 2023) for 10.45% p.a. If you’re a frequent flyer, you’re able to take a loan out at 11.45% p.a. to earn Qantas points on your investment loan.

Of course, their Product Disclosure Statement (PDS) shows a variety of outcomes, including equal loss and gain scenarios. What it leaves out of these scenarios is the impact of fees.

If you’re holding a loan that’s costing you 10.45% per annum that is at a significant detriment to your total returns. This fee is taken regardless of whether you make the right call or not. It also accrues daily.

The below graph shows the impact of fees on a $20,000 loan over two years, that earns 5%. Of course – this is on funds that you would not have had without leverage.

Source: MoneySmart

As previously stated, given the high interest rates of margin loans the investments that are made are inherently short-term in nature. MoneySmart, a government agency, recommends that if you are going to employ leverage with equity investments that it should be a long-term investment of around 5-10 years.

There aren’t any reliable figures about average holding periods of margin loans/leveraged equities in Australia. However, there are similar instruments that function practically the same way that show how investors behave when it comes to gearing investments.

Contracts for Difference (CFD) are a decent comparison. A CFD is a contract between a buyer and a seller – and the contract stipulates that they exchange the difference in value between the time the contract open and closes. The assets that are usually linked to CFDs include FX, indices, equities, commodities and even crypto.

With CFDs, you use leverage – and you pay interest on any borrowing.

In Australia, the average holding time for a CFD is 3 days.

CFD instruments are already banned in the US and Hong Kong because of their speculative nature, and the disastrous financial consequences they can have.

In Australia, there have been many revisions and continued conversations on how to make these instruments ‘safe’ for investors. These revisions have made a marked difference to reducing the losses incurred by retail investors, but retail investor losses are still significant.

According to ASIC, CFDs were the most purchased financial product since 2020, and 42% of investors sold at a loss. 

Built to be held for short periods, and sold at a loss

Warren Buffet has said about leverage ‘If you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke, basically’.

Successful use of leverage can accelerate the timeline for building wealth. The issue is that the successful use of leverage is dependent on a lot of variables. Over the long-term the success of a particular share is based on the success of the company. Over shorter periods of time the variables that impact a share price have less to do with the company and more to do with random occurrences. Share price returns can be driven by geo-political events, an economic announcement, an announcement by a competitor and general market sentiment.

Over the short-term security price movements are essentially random. This doesn’t matter for longer-term investors. It is just noise. For a short-term investor employing leverage the randomness of security price movements is the equivalent of going to the casino and betting on black at the roulette table. Any fall in price could trigger a margin call which requires an investor to add more cash to their account or to sell. Your losses can exceed the amount of money you’ve originally invested.

An example of a margin call

Say that you invest $10,000 into stock A, and you take on $10,000 in leverage. Your position in stock A is $20,000. You have a maintenance margin of 25%. To work out your minimum account value, it would be your margin loan amount divided by (1-maintenance margin). In this instance, it would be $10,000/0.75.

$13,333 would be the minimum account value before a margin call is triggered. This means that if your account value drops below this amount, you will have to top up your account.

Other ways that investors can lever their investments

Alongside margin loans and CFDs, you are able to purchase managed investments with leverage built in. The leverage is managed within the portfolio, so you don’t have to deal with margin calls or maintaining the leverage.

These managed investments come in both active and passive. Betashares offers a passive geared Australian ETF (GEAR). This gearing ratio is between 50-65% and invests in the ASX 200.

Here is a snapshot of the current managed funds with leverage in Australia (at 20 November 2023).

Those returns look pretty good over the longer term. Investors are rewarded for taking a risk with active management and doubling down on their bets with leverage.

However – you can and will experience different market conditions in the future. On average, we experience a bear market every three years. There were three managed funds that were operating during the Global Financial Crisis. The results look very different.

At one point, the Perpetual Geared Australian Fund dropped to less than 25% of its original value.

Leverage is a story of extremes. To understand whether it has a place in your portfolio, you have to understand the type of investor you are. You have to understand what you are trying to achieve and why you are using leverage. Is it because you have faith that the market will go up? Will you be able to beat the 10.45% hurdle with a margin loan through bull markets and bear markets? Is it a speculative investment? An investment you’ve made to squeeze as much return out of the capital that you have?

Leverage is used in portfolios when you’re trying to maximise your wealth as quickly as possible. Ultimately, this is not investing – especially if you’re made to sell your position. This is the way that leverage is inherently paradoxical. We use it in our portfolios to maximise wealth over the short-term and use long-term market returns as justification. In this process, we are reducing the chances of compounding by potentially locking in losses.