Leverage in investment – sometimes a great notion

There is no shortage of warnings about leverage, and there is plenty of evidence that it has often been at the heart of financial crises. Nevertheless, leverage is widely used in investment portfolios, and sometimes to good effect. By amplifying exposure to an asset class, it can improve returns. However, the warnings are well-founded and leverage needs to be employed with caution.

Whether used by investors or companies, financial leverage involves borrowing money to invest in assets, or some transaction that amounts to the same thing. If the return on those assets exceeds the cost of borrowing the funds, an investor will boost their return without having to commit extra capital. However, the opposite is also true – leverage can vastly magnify losses if an investment turns sour.

In practice, investors use leverage all the time – to buy a house, to take the most commonplace example – and it has plenty of sensible uses, but it can also be a source of instability and volatility. The global financial crisis of 2007-2008, for example, had its roots in excessive leverage in the US housing market and derivative products based on it, which meant that a meltdown in a relatively small corner of the financial system had an outsized effect.

Lehman Brothers’ huge portfolio of mortgage-backed investment products was four times the value of its shareholders’ equity. This high level of leverage, particularly in the mortgage-backed securities market, was a major contributing factor to the firm’s vulnerability and eventual collapse during the crisis. Other renowned institutions only avoided that fate by being acquired by groups with more solid financial foundations or being bailed out by governments.

There are a number of ways to create leverage. Bank loans are a relatively straightforward option

Alternative forms of leverage

There are a number of ways to create leverage. Bank loans are a relatively straightforward option: investors know the interest rate in case of fixed rate loans, the exact amount they need to repay and the length of time over which repayments are due. This means it is easy to understand the hurdle rate for any investments made with bank leverage. For instance, in a scenario where the loan carries a 3% interest rate across a five-year period, it is essential to secure a minimum annual return on investments that matches or surpasses this rate, in order to both repay the loan and realise a profit.

Floating rate borrowing, such as an overdraft, comes with greater risks because it leaves investors vulnerable to changes in interest rates. These risks have been amply illustrated by the rapid rise in rates in 2022 and 2023 as central banks have sought to tamp down inflation. Borrowers who embraced leverage assuming that rates would remain as low as 2% or 3% have now found themselves facing much larger interest payments than expected, which may not be matched by their returns. In any case, it’s important for individuals and businesses to compare the costs of different credit options and consider the suitability of each option for their specific financial needs and circumstances.

It is also possible for well-informed investors to use derivatives to introduce leverage into a portfolio. Rather than using debt to buy a larger volume of a particular asset, derivatives allow investors to obtain exposure to the asset without actually owning the underlying asset or requiring the full capital outlay typically needed for direct investment.

Derivatives are generally the least predictable and stable type of leverage because prices move around every day. Some types of derivatives expose investors to the risk of their losses being magnified, which is why Munger’s long-time investment partner Warren Buffett christened derivatives “financial weapons of mass destruction”.

Why would investors risk using leverage?

Leverage can amplify your investment power – it provides enhanced exposure to the underlying asset with the same initial investment. In times when borrowing costs are low and economic growth is sluggish, leverage can be strategically utilized to augment returns in a market that is otherwise lacklustre.

However, it’s crucial to remember that leverage acts as a double-edged sword in investment: while it has the power to magnify returns, allowing investors to achieve greater gains from a smaller initial capital, it also increases the potential for substantial losses. This dual nature arises because leverage amplifies the effect of market movements; if the market moves favourably, gains are boosted, but if it moves against the investor, losses are similarly magnified, underscoring the need for careful risk management.

For the most part, however, leverage may be used mainly to help gently magnify, modestly enhance the returns of an investment over time, capitalizing on the usual upward trend of markets, particularly when borrowing costs are low. Companies also leverage for acquisitions or to invest in technology and machinery. Investors typically gauge a company’s leverage through its debt-to-equity ratio, measuring borrowed funds against shareholder capital. Excessive debt, however, poses a risk; should the investment falter, shareholders face the potential of significant capital loss.

Collective investments

Most regulated collective investments have strict rules around gearing. With UCITS funds, for example, borrowing for investment purposes is permitted, but it must be from first-class credit institutions, on a temporary basis and is subject to a limit of 10% of the fund’s net asset value¹. European Long-Term Investment Funds (ELTIF) may use up to 50% leverage if they are marketed to retail investors and 100% if they are restricted to professionals.

For alternative investment funds, leverage limits are set by a fund’s home regulator, to which it must provide extensive information. There are limits on exposure to individual lenders. Funds must disclose their policy on leverage, how leverage is taken and its impact on their risk profile. Requirements are often less strict for closed-ended funds.

Used judiciously, leverage has its place in a portfolio to help magnify returns prudently and to take conviction positions on specific investments. For companies, it’s a common and a faster way to grow than investments out of retained profits. However, leverage can also entail significant risks. Again, the final word goes to Warren Buffet: “Whenever a really bright person who has a lot of money goes broke, it’s because of leverage. It’s almost impossible to go broke without borrowed money being in the equation.”

Leverage gives you more bang for your buck – greater exposure to an underlying asset for the same initial outlay, and when debt is cheap and economic growth anemic, it can be a tool to boost returns in an otherwise moribund market.

¹ Leverage used to invest in Real Estate may bring that threshold to a total of 15% under certain circumstances.