How to Invest with Leverage Safely
Investing with leverage, or borrowing, to boost returns is something that has been around for a long time. But up until about 20 years ago, it was exclusively for institutional investors. And after going through the stock market crashes in 1987, 1998 and 2001, many banks had balance sheets littered with the worthless stocks for which they had loaned up to 50% of the original value. But still, we persist with leveraged investment. About 15 years ago, leveraging was opened up to private banking and other affluent customers through Pledged Asset Lines or Portfolio Lending. Today, almost everyone can access margin financing for their stocks and funds through a multitude of bricks-and-mortar and online brokerages. Hence financing for investing is much more mainstream now. But the question remains – How to invest with leverage safely?
That investing with leverage carries higher risks is obvious. This is so even for the case of experts. We only have to look at the cases of Nick Leeson at Barings Brothers, Long Term Capital Management, Bear Stearns and Lehman Brothers, JP Morgan Chase’s London Whale, Bill Hwang’s Archegos Capital Management, to name a few, to know of the risks. In every single case, borrowing too much, or excess leverage, led to spiralling losses when the values of their trades tanked.
Regardless, we also dream of being the next Warren Buffet, George Soros, John Paulson, Ray Dalio and many others who have skilfully used leverage to earn passive returns. So let’s take a look at how we can use leverage in investing, and hopefully, in a safe manner.
Leverage in Investment must be used with Care!
The basics of investing with leverage
Let’s start with a few basics about investing with leverage. The key things which you would need to understand are:
Loan-to-Value (LTV) is simply how much you can borrow against your position. And this usually decreases with the riskiness (in terms of volatility of the price) of the investment. So, for very safe investment grade bond funds, the bank or broker might be willing to lend you up to 80% of the value of the position. For large-cap, blue chip stocks, perhaps 70% of the value, for other medium to large cap stocks, perhaps 50%. Anything below 50% LTV is probably not worth considering, as the low level of leverage will simply not yield much benefit in terms of returns.
The main forms of risks you will be facing is price risk, and margin call risk. Price Risk is the same risk as you have with any investment, that the value may fall. Only that if you have borrowed say, 50% against your investment, or leveraged up 2X, the price risks are also magnified twice. So while we may expect a stock to rise or fall by up to 5% on a weekly basis, a twice leveraged stock position will rise or fall by 10% instead.
Margin Call Risk is the risk that as the value of your investment falls, the bank or broker will ask you to top up your position with cash. Or they will sell your investment. At the worst possible time too, since this will be when its value has dropped. For example, if the bank or broker is willing to lend you 50% against an investment, or $50 against a $100 investment, when the investment falls by 5% to $95, the bank will be lending you $50 against a $95 investment. Hence, you will be asked to make good the investment value to $100, either by putting in $5 in cash, or allowing the bank or broker to sell down your investment to $90, and take the $5 to reduce their lending to $45.
Of course, when you have a huge investment position, like Bill Hwang at Archegos Capital, the forced sale of your investment may depress its value even further, leading to more forced sales, and so on. This then becomes a death spiral which ultimately sinks your investment and more than that!
Borrowing is obviously not free, even when short term interest rates are as low as they are today. Looking across a range of brokers, we see that borrowing costs range from around 1.5% per annum to more than 3%. If you have a wealth management relationship with a bank, you may even pay as little as 1% to 1.25%. While brokers have made it very easy to get financing for leveraged trading and investment, note that the ones with the lowest rates are also the ones who will force sell your positions in a heartbeat. Banks tend to be a little better, allowing a grace period for topping up your margin, as they would be loathe to lose a good wealth management customer.
Finally, we can put all this together to work out the returns. Suppose you invested in a stock index like the S&P500 with an expected return of 8% and a volatility of 15%. And further suppose you leveraged 2X, or borrowed 50% against your investment. How would you expect to fare? We work this out below:
Expected Returns from 2X leveraged position in S&P500 ($50 capital, $100 invested)
|Returns on $100 investment at 8%||$8.00|
|Costs of borrowing $50 at $1.5%||$0.75|
|Net earnings after costs||$7.25|
|Rate of return on capital of $50||14.5%|
By leveraging 2X, we have almost doubled our expected returns compared to just simply investing in the S&P500 without leverage. But we have also doubled the risk. And what this means is that the Sharpe Ratio remains exactly the same, whether we are leveraging or not. In short, we expect to get the same returns per unit of risk taken. If we leverage up even more, say 3X (i.e. an LTV of 67%), we get even more returns, but at the same Sharpe ratio:
Expected Returns from 3X leveraged position in S&P500 ($33 capital, $100 invested)
|Returns on $100 investment at 8%||$8.00|
|Costs of borrowing $67 at $1.5%||$1.01|
|Net earnings after costs||$6.99|
|Rate of return on capital of $33||21.2%|
This expected return of more than 21% looks like a fantastic deal for those who can swallow the risk. No more waiting years and years for the stodgy stock index to compound over time! So what’s the catch? The catch is of course the same as what tripped up all those other cases like Archegos Capital and Long Term Capital Management. Investment values rarely go up in a steady straight line. Instead rallies are followed by breathtaking drops and corrections. And much more so when you are leveraged 2X or 3X. It just takes one sharp correction for the bank or broker to force sell the entire investment and wipe out your capital. And you may end up owing more than just that.
How to Invest with Leverage Safely? Use Bonds Instead
Having seen how leveraging when investing in equities can make you penniless in double quick time, how then can we make use of the cheap credit that is gushing all around us for investment? While there are successful investors who have used leverage with their equity investments, let’s not forget that the most successful users of leverage are the banks themselves! Indeed, the ones who are lending to you for investments probably do understand it a bit better than most. If you think about it, banks operate with as little as 3% of their assets in the form of shareholder capital, with borrowings (through deposits mostly) making up the rest. So in general, banks can be as much as 33X leveraged!
But instead of putting this 33X leverage at work through risky equity, foreign exchange and commodity investments, banks put their leverage to work in bonds and loans. That is, borrowing short term to lend long term. Does this work? Sure it does! Just take a bank, putting $10 of its own capital to work alongside $90 of deposits paying 0.25% to make a housing loan of $100 which charges 1.5% in interest. After one year, the bank earns $1.5 in loan interest, and pays $0.225 to the depositors, earning itself $1.275. This corresponds to a 12.75% return on equity! Do it on a large enough scale, and you can see how banks can earn billions in profits every year.
What is actually more interesting about the way banks manage their leverage and investments is that this is done with almost no risk of falls in investment value and margin calls, mainly because the loans are not marked-to-market for accounting. This is because as long as the loan underwriting was done carefully, there is actually very little chance of loss. So one of the ways to invest with leverage safely, is to invest in loans or bonds.
Leveraging bond investments
As individual investors, we cannot really invest in low risk loans like a bank, but we do have access to bonds (at S$250,000 per investment for SGD bonds and US$100,000 for USD ones). In today’s low interest rate environment, investment grade bonds yield around 2% per annum. We also have access to low risk bond funds (which we talk about here) which can yield around 4% or even 5%, with a volatility of around 5%. As we explain, holding bond funds pays off better than bond index ETFs because of active management. Holding bond funds is also safer than holding individual bonds, as any holder of Hyflux or Swiber bonds can tell you.
How would a leveraged investment in bond funds pay off? For a start, most banks and brokers are willing to lend up to 80% LTV against a low risk bond fund. But let’s not be too ambitious (or run the risk of a margin call) and start off with just 3X leverage (67% LTV) instead of the maximum 4X. Let’s run some numbers:
Expected Returns from 3X leveraged position in a bond fund ($33 capital, $100 invested)
|Returns on $100 investment at 4%||$4.00|
|Costs of borrowing $67 at $1.5%||$1.01|
|Net earnings after costs||$2.99|
|Rate of return on capital of $33||9.1%|
Basically, leveraging a small position in a bond fund up to three times the invested amount can give us an equity fund type of return of 9%. But at the same time, it also gives us an equity fund level of risk, at 15% volatility per annum, which is again three times the volatility risk in an unleveraged bond fund. The Sharpe ratio of this leveraged bond fund investment also looks the same as the unleveraged equity fund investment. So what is the big deal about investing with leverage if all you are going to do is to leverage bond funds?
The risk parity portfolio
Clearly, looking at the leveraged bond fund investment by itself yields us no insight into why we should bother with leverage in investing, unless we are shooting for very high returns with very high risk. But nobody invests in a singe asset. Most, if not all, investing (as opposed to trading) is done on a portfolio basis. And the purpose of leverage on a bond fund is to help us build the risk parity portfolio.
Let’s review a bit of modern portfolio theory (MPT). In MPT, as we invest in more and more equity securities, we get diversification, or reduced risk, without sacrificing any returns, unless the portfolio is very concentrated. Points on the efficient frontier of returns (y-axis) versus risk (x-axis) are the best trade-offs given the desired level of risk or returns. Any point beyond this efficient frontier is not possible with an unleveraged portfolio of stocks.
Efficient Frontier for an Unleveraged Stock Portfolio
Now, we can draw a Securities Market Line (SML). This stretches from the level of the risk-free return on the y-axis, and touches the efficient frontier. The point of tangency, or where it touches the efficient frontier, represents the highest or best risk-reward trade-off available. This is where the highest Sharpe Ratio for a unleveraged stock portfolio occurs. That is to say, we cannot do better than portfolio A given the stocks we can choose from, from a risk-return perspective.
We can get higher returns of course, but at the expense of taking on more risk, and the usual way to do so and still maintain the Sharpe Ratio is to borrow at the risk-free rate (or close to it) and leverage up the stock positions. This is shown by point B below. This is also what margin financing offered by banks and brokers does, by letting the investor leverage up stock positions.
Efficient Frontier on the Securities Market Line with Leverage
But for a risk parity portfolio, instead of leveraging the stocks for more return, we instead leverage the bond funds to get the same return and volatility as the stock portfolio. The difference here is that the correlations between the bond fund portfolio and the stock portfolio are lower than between stocks and stocks (which is what you get when just leveraging up the stocks). This means that we can maintain the returns at the level of portfolio A, but now have less risk at portfolio C.
Effects of Risk Parity Portfolio with 50% invested capital in stocks and 50% in leveraged bonds
This looks like there is a second free lunch in investing (after diversification, which is the first one)! But we can assure ourselves that this works by looking at some numbers. Let’s assume we invest the same capital in bond funds and in stocks, and then leverage the bond funds to get the same returns and risk on invested capital for the bond funds as what we can get for stocks. The difference between the columns below is due to the correlation between the bonds and stocks. The extreme case of 100% correlation is just a reference as the true correlations should be between 0% and 25%.
|100% Correlation||50% Correlation||25% Correlation||0% Correlation|
So, how do you invest with leverage safely? Well, the safest way is not to max out the LTV, leverage only with low risk bond funds (which give you a higher LTV anyway), and do it in a portfolio with stocks to get the benefit of diversification through a risk parity portfolio!
How to invest with leverage safely? Do not max out the LTV, leverage only with low risk bond fund investments, and do it in a portfolio with stocks to gain the benefits of diversification through a risk parity portfolio
A few caveats to making this sort of investing with leverage work
Capitalising on the seemingly unstoppable rise in global stock markets over the past few years (even through the COVID-19 crisis!) banks and brokers have offered margin lending for securities trading to all manner of investors. Seasoned, old, young, and first-timers. Using margin financing to trade in high risk stocks is a risky path that can lead to loss and even bankruptcy. How, then, can we invest with leverage safely? The old investors may tell you never, but in the current market environment, there is a way to do so safely, with low risk bond funds.
But this is not something which always works. A few things to keep in mind:
- Leveraging works only if borrowing rates are low, around 1.5%, and definitely not more than 2%
- Investing with leverage is only worthwhile if the returns of the asset being leveraged are at least 3% or more
- Use leverage to get close to an equity portfolio return, but never, ever max out the LTV, because that would risk a margin call whenever the market wobbles
- Leveraging in this way is a carry trade, it works until it suddenly fails, because there is still interest rate risk in the mix, but this can be minimised, and will need to be monitored
We’ll back again soon, to talk about How much leverage should I have? Watch for it!