The concept of leverage is crucially important throughout finance, but many investors may not have a real grasp on the meaning of this term. Leverage refers to the practice of borrowing money to increase your exposure to a specific investment. A home mortgage is a form of leverage. If you put down 20% when you buy a home and the house value appreciates by 20%, your actual return on your investment is 100%. Such is the power of leverage. On the other hand, if the price of your house drops by 20%, you have lost 100% of your investment.
Investors in the stock market take on leverage in a variety of ways. Investors can borrow money from their broker and invest that money–this is called trading on margin. Margin provides leverage.
Another way to take on leveraged positions in the stock market is to invest in a leveraged fund. SSO, for example, is a 2X leveraged S&P 500 ETF which means that the fund takes on positions so that a 1% move (up or down) for the day in the S&P 500 will result in a 2% move (up or down) in the fund. Leveraged ETFs are somewhat controversial because it appears that many investors do not understand how leverage in these ETFs is achieved. One key point to remember with respect to leveraged funds: leverage is not free.
If you wanted to create a $10,000 2X leveraged position in the S&P 500, you could either buy SSO with your $10,000 or you could borrow $10,000 from your broker and then invest your original $10,000 plus the borrowed $10,000 for a total investment of $20,000 in the S&P500. When you borrow money from your broker, you pay interest–just like any other loan. This interest means that you have a source of loss in your leveraged position. If you buy SSO, the costs of leverage are hidden in the fund, but you can be assured that you are paying for the implicit borrowing.
There is an even less well understood form of leverage that involves selecting investments on the basis of Beta. If you invest in SSO to achieve a 2X leveraged position vs. the S&P 500, the Beta of your investment is 200%. The Beta of the S&P 500 is 100% (by definition). A Beta of 200% with SSO means that you have used leverage so that your portfolio moves 2% for a 1% move in the S&P500. What if you simply bought a portfolio of stocks with Beta of 200% but without any margin? High Beta stocks can allow you to create a leveraged portfolio without taking on any margin or buying a leveraged fund. For a useful discussion of this form of leverage, see the following article. This article poses the following question:
Question: Which of the equity portfolios below has the greatest risk, if risk is defined by the portfolio’s stock market risk (beta)? Assume each portfolio has the same capital, and that the stock betas do not change for the analysis period.
Portfolio 1: Uses all of its capital to buy a stock with a beta of 200%.
Portfolio 2: Borrows funds equal to its capital and invests all of the money (initial capital plus borrowed funds) in a stock with a beta of 100%.
Answer: Both equity portfolios have the same market risk as each portfolio has an aggregate beta of 2. The key point is that the same risk level is achieved through different types of leverage: Portfolio 1 invested in a risky stock with a beta of 2 (i.e., it used instrument leverage), Portfolio 2 used borrowing leverage.
Whether or not investors are explicitly aware of leverage, most use leverage in some form in their portfolio planning. Leveraged funds and home mortgages are obvious sources of leverage, but the idea that the Beta of an investment portfolio represents a form of leverage is not well-understood. Imagine the case of an investor who believes that the market is going to go up in the near term, so she wants to have increased exposure to the market. She might buy the 2X leveraged ETF. Conversely, she might leverage up against the market by creating a portfolio of stocks with Betas greater than 200%. Such a portfolio might include American Express (AXP, Beta of 218%), Bank of America (BAC, Beta of 244%), or Prudential (PRU, Beta of 263%). A simple screen that will identify larger firms with high Betas is available from Yahoo! Finance.
Understanding leverage is very important. Investors who would not think of borrowing money to leverage their positions in the S&P500 may still have portfolios with Betas well over 100%, so that they are implicitly leveraged against the S&P500 anyway. Many investors were shocked when their investments in emerging markets dropped dramatically along with domestic equities. Way back in 2006, before the crash, the Betas of some emerging markets ETFs were upwards of 200%.
Leverage is a powerful and useful tool, and investors will benefit from understanding how leverage impacts their portfolio performance. The biggest risk is that investors may end up taking on positions that are effectively leveraged without understanding the potential downside.