Leverage is a powerful tool investors use to try to magnify returns, but as with any investment strategy, there’s no guarantee leverage will always accomplish its goal.
Leverage means using debt (or borrowed capital) to fund an investment. If the return on the total amount invested is higher than the interest on the borrowed money, then the investor made a profit by using leverage.
It’s a risky play, since it comes with the possibility of losing more than you invested.
Anyone contemplating leverage needs to make sure this strategy meshes with their overall financial goals, time horizon and tolerance for risk.
Buying on Margin
Buying on margin involves borrowing money from a brokerage firm to purchase securities. Typically, investors can borrow up to 50% of the purchase price of marginable investments — effectively doubling their purchasing power. The financial assets usually form the collateral for the loan, but an investor may be required to pledge other collateral, depending on their financial status and the proportion of the overall investment funded with borrowed money. Investors must also pay margin interest on any outstanding balances.
Buying on margin amplifies your potential gains and losses. If you buy on margin and your investment goes down in value, you still owe the margin debt — plus interest. And, if the value of an investment falls far enough, the broker will issue a margin call that requires the investor to deposit additional money or securities into the margin account to satisfy the firm’s minimum equity requirements. The broker is also able to sell from your margin account to bring the account back into good standing, without need for permission or notification.
Leveraged mutual funds and exchange-traded funds (ETFs) attempt to deliver multiples of the performance of the underlying index or benchmark they track, which could be a broad index, a specific sector or commodity or even a blended benchmark. They are usually offered as 2x or 3x the return on their benchmark. Leverage arises by virtue of the fund’s exposure to underlying assets being greater than the amount invested.
Consequently, any adverse change in the value or level of the underlying asset, rate or index will amplify losses compared to those that would’ve been incurred if the underlying asset had been directly held by the fund.
Leveraged funds seek to magnify returns via the use of financial instruments like derivatives, futures contracts, and swaps. The borrowing and interest charges occur within the fund, so investors don’t need to worry about margin calls or losing more than their principal investment. This makes leveraged funds a lower-risk – but not low risk – leveraged investing option.
Short selling is when an investor believes an investment will decline in price and borrows the security to lend to a counterparty. Short selling gives investors the opportunity to generate returns in a variety of market environments — not just up markets. Short sellers expect that they’ll be able to purchase the security at a lower price at some future date, to close out the short position, and keep any difference between the lending and covering prices. With short selling, you owe rather than own, a security that you will have to repay at some point.
Investors must satisfy initial margin requirements to open a short position and pay interest on the value of the borrowed securities while the position remains open. Shorted securities are held as loan collateral by the brokerage. Investors must have the means to manage the funding of their short positions and the risk of a call — when the short position must suddenly be covered or closed out. If unable to post sufficient margin, the brokerage can sell out your position to bring the account onside, without need for permission or notification.
With buying on margin and short selling, investor losses are infinite. For leveraged funds, the maximum loss is what was invested into that mutual fund or ETF.
Experts usually suggest investors only take out a loan for no more than half the amount they qualify to borrow. To be conservative, you shouldn’t borrow more than 25% of what you can access.
This makes sense from a risk management perspective, and when leverage works, the heightened returns can become addictive. After having benefited from leverage, investors may find it difficult to return to conservative practices and the commensurate lower octane returns.
Are you a good candidate for leverage?
You might be a good candidate for leveraged investing, if:
- You can handle heightened market volatility affecting the value of your investments
- You have a strong risk appetite and are an experienced investor
- Your investment horizon is lengthy, and you can stay focused on long-term results
Anyone considering leverage would be well advised to seek professional advice, given the complexity and risks involved.
Leverage offers investors a means to increase their returns, but employing leverage comes with some big risks. Investors must determine whether the additional risk borne in pursuit of heightened returns is sufficient to justify leveraging their investments, and it should be used with caution, especially by novice investors.