Investing With Leverage (Borrowing to Invest, Leveraged ETFs)

Summary

In this Common Sense Investing episode, Ben Felix from PWL Capital discusses the role of leverage in boosting investment returns. He explains how leveraging a well-diversified portfolio can lead to better outcomes than concentrating on risky assets. Felix also highlights the risks of leverage, such as magnified losses and the cost of borrowing. He explores the use of leverage by young investors for time diversification and the practicalities of borrowing for investment, including home equity loans and margin accounts. Finally, he touches on leveraged ETFs, their design for daily leveraged returns, and the challenges they pose for long-term investors due to volatility and time decay.

Takeaways

• 📈 **Volatility Concerns**: Investors worried about volatility can add bond index funds to their portfolio to match their risk preferences.
• 💹 **Risk-Taking Investors**: For those willing to take more risk, options include reducing diversification or using leverage.
• 🚀 **Aggressive Investing**: Aggressive investors might consider investing entirely in a diversified stock portfolio or focusing on the riskiest stocks.
• 📉 **Risk and Reward**: Cheap stocks, which are considered risky, can potentially offer higher returns.
• 🔄 **Diversification vs. Leverage**: Leverage on a well-diversified portfolio is suggested to be a better strategy than increasing concentration in risky assets.
• 💼 **Leverage Defined**: Leveraging means investing more in an asset than the amount of your own money, often through borrowing.
• 📊 **Impact of Leverage**: Leverage can amplify both gains and losses, doubling returns with borrowed money but also doubling losses.
• 💵 **Cost of Borrowing**: The cost of borrowing is crucial as it can nullify the gains from leveraged investments.
• 🏡 **Borrowing Options**: Home equity is a cheaper form of borrowing, but other forms like margin loans come with risks like margin calls.
• 📚 **Youth and Leverage**: Young investors with less cash are advised to consider leverage to increase stock exposure, balancing it over time.
• 📊 **Leveraged ETFs**: Leveraged ETFs offer leveraged exposure without directly borrowing, designed for daily leveraged returns, not long-term holding.

Q & A

What is the primary concern of investors who add bond index funds to their portfolio?

Investors who are concerned about volatility in their portfolio might add a bond index fund to reduce expected volatility, even though it also reduces expected returns.

What are the two options for investors willing to take on more risk than the stock market offers?

The two options for such investors are reducing diversification or using leverage.

Why might an aggressive investor consider focusing on the riskiest stocks in the market?

Focusing on the riskiest stocks can potentially lead to higher expected returns, as these stocks are priced as risky by the market.

What is the downside of reducing diversification in a portfolio?

Reducing diversification decreases the reliability of outcomes and increases exposure to specific, uncompensated risks associated with the few companies invested in.

How does leverage theoretically increase expected risk-adjusted returns?

Leveraging a well-diversified portfolio can lead to better expected outcomes than increasing concentration in risky assets, as suggested by a 2012 paper from AQR.

What does investing with leverage mean?

Investing with leverage means getting more exposure to an asset than the amount of your own money invested in it, often through borrowing money to invest.

How can leverage impact returns and losses?

Leverage can double returns if the investment performs well but can also double losses, and a significant loss can wipe out the entire investment.

Why might young investors consider using leverage according to Ian Ayres and Barry Nalebuff?

Young investors have less cash to invest but need significant exposure to stocks; leveraging allows them to increase this exposure early on and maintain more consistent exposure throughout their investment lifetime.

What are some practical considerations when using leverage?

Practical considerations include lenders' willingness to lend based on the borrower's ability to repay, the cost of borrowing, and the risks associated with callable loans and margin calls.

What is a leveraged ETF and how does it work?

A leveraged ETF is a financial product designed to deliver a multiple of the returns of an index. It uses derivatives to achieve this and is designed to match the levered returns for a single trading day.

Why might the long-term performance of a leveraged ETF differ from its daily performance?

The long-term performance can be affected by volatility and the daily rebalancing effects of the leveraged ETF, which may not align with the long-term leverage return suggested by the product.

What behavioral challenges does leverage present to investors?

Leverage amplifies behavioral risk, as most investors tend to make poor decisions at the worst times, which can be exacerbated by the increased exposure to risk that leverage provides.