What is leverage, and is leverage good or bad for us as individual investors?
Personal note on leverage: I personally try to stay away from leverage. Our investments in stocks, portfolios and digital assets are made with $0 debt. The only exception is real estate rental properties.
What is leverage in stocks?
Leverage in investing refers to debt. It means you borrow money to make an investment or to amplify your position.
Like leverage in physics, financial leverage helps you move a higher load (make a bigger investment) with less effort (less required capital).
Leverage is an amplifier.
Effects of leverage on investment
This amplifier means that your positions will be larger. That’s great, isn’t it? Well, larger positions mean that you will reap higher rewards when the investment goes up and experience higher losses when the investment goes down, and you decide to sell.
So the expectation is that profits you expect to earn from a leveraged investment will be greater than the interest expense on the debt.
That means interest rates play an important role in deciding whether to use leverage or not. With low interest rates like we have today, many investments can potentially beat the interest that needs to be paid.
Let’s say you have access to a 3% credit line. Using that credit line to amplify your position in a portfolio that generates 6% income makes sense.
If the expected return is much higher than that, then using leverage becomes extremely attractive.
But never forget that whatever happens to your investment, you still owe money to the borrower. That means in the seemingly harmful example I mentioned above, if the portfolio were to fall drastically, you still need the money to repay the credit line. Debt doesn’t go away. This brings me to the point that many forget, especially during long bull runs.
Leverage increases volatility
This may seem obvious, but using leverage increases volatility significantly.
Let’s take an example of buying a stock for $100 using debt for 50% of the purchase price. You invest $50 of your own money and borrow another $50.
Then the stock falls by 50%, and you need the money, so you sell it for $50. You use that $50 to repay the debt, and you are left with $0. You amplified your position by 2x, your losses are 2x or in this case, a whopping 100%.
But so are the gains. If the same stock goes up by 50% and you take the profit, you sell it for $150. Use $50 to repay the debt, and you are left with 2x your original investment, or $100.
There are other ways to get a leveraged stock market investment, and that is through a leveraged ETF. In that case, you are not the one borrowing the money, but the ETF managers use various financial tools to amplify returns of whatever benchmark they follow.
Similar to my stock investments, I stay away from leveraged ETFs.
Leveraged ETFs long term effects
The reason I stay away from leveraged ETFs is that I consider myself a long-term investor. All my investments have a time horizon of at least a year, and most have five years+ expectations.
I cannot expect long-term results from leveraged ETFs. I am generally bullish about the U.S economy and the S&P 500 over the long term. I absolutely love having a simple stock market ETF as part of my retirement portfolio.
If I am so bullish, then why wouldn’t I want to 2x or 3x my bullish outlook with a leveraged ETF like SSO – The ProShares Ultra S&P 500.
Leveraged ETFs don’t just borrow money to increase their positions
ETF like SSO don’t go to the bank, take out a loan and buy the S&P500.
Here is SSO’s mandate:
This leveraged ProShares ETF seeks a return that is 2x the return of its underlying benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, holding periods of greater than one day can result in returns that are significantly different than the target return and ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.
So the ETF tries to 2x daily return and that completely messes up the long-term effectiveness of such a strategy. Suddenly this becomes a traders tool, not investors.
Daily resets can crash our returns over a longer than one day holding period
Here is how. Let’s say you buy the ETF at $100. The S&P goes down by 5%, which means the ETF is down by 10% or $90. The next day’s recovery of 5%, brings your position by 2x that so 10% or $99. The S&P 500 completely recovered, but you are still down 1%.
Extend this dynamic over a long period of time, and it doesn’t matter what the S&P does; you are very likely to lose money.
Leveraged ETFs High Fees
Doing this costs money to the managers who run these ETFs, and that means they pass the cost down to us in the form of fees. SSO, for example, has an Expense Ratio of 0.91%. Compare that to S&P 500 ETF SPY that has an expense ratio of 0.0945%.
Hopefully, that is enough to deter you from thinking about leveraged ETFs as long-term investments but for the sake of the analysis, let’s do a historical comparison.
SSO vs SPY
Here is a hypothetical $10,000 investment made in each ETF at the end of 2006.
SPY has been outperforming its leveraged counterpart for the majority of the time. Only in the last very bullish 2.5 years has SSO come out on top.
Here are key statistics:
Given the volatility, higher fees and cyclical nature of the markets, leveraged ETF like SSO just does not make sense for investors.
So Is leverage good or bad?
Leverage makes sense in some cases and is absurd in others. In the example of borrowing some money to increase your position in the asset that consistently beats the interest rate you have to pay on the loan, that makes sense.
Buying a leveraged ETF for the long-term does not. Borrowing excessive amounts of money in hopes to increase gain is a sure way to ruin.
To quote Warren Buffet once more:
I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.
Businesses and people don’t go bankrupt because of poor investment decisions. As bad as that will be, Investments either recover or you learn a lesson and take a loss but you don’t lose everything. Bankruptcy comes from the inability to repay the money you borrowed, so always keep that in mind.