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Leverage Is a Tool to Be Used Only When Understood Print PDF
The Invest With An Edge Blog featuring Peter Mauthe

Last week Trevor Hunnicutt reported in ETF.com’s daily posting that the SEC approved quadruple-leveraged ETFs. This is the first time 4x leverage has been approved for use in ETFs in the United States. Leverage is used in many ways in financial transactions. In the structure of domestic mutual fund products, leverage available to the public until now has been limited to 3 to 1 (3x leverage).

Let’s start with a brief discussion about leverage. Leverage in the financial markets is the use of borrowed funds or structured contracts, such as options and futures, to gain access to exposure to a market beyond what actual cash may be put up. Examples of the use of leverage include people putting money down and getting a loan to buy a house, a business doing the same thing to build a plant, and an airline putting money down as a good-faith deposit on a futures contract covering the fuel they will need in December. In all of these examples, leverage was used to magnify the purchasing power of the amount of money put down on the transaction. Leverage is not inherently a bad thing. It is a financial tool widely used by individuals, businesses, and governments. It can be used wisely and unwisely.

Mutual funds (including ETFs) are generally not allowed to borrow money to buy securities, even though doing so is a common practice in the financial industry. Many years ago funds were allowed to use options and futures within their portfolios to manage risk and to gain exposure to stocks and bonds without committing all of their available cash. This set the stage for what are known as leveraged funds.

Anytime leverage is used to magnify exposure to securities, it does so both in up market moves as well as down. An ETF that uses 2x leverage magnifies each dollar in the ETF by a factor of 2, and so on for 3x and 4x ETFs. The following graph illustrates a $10,000 investment in a 1x, 2x, and 3x S&P 500 ETF over the past five years. Notice that both the rising and falling moves are magnified by a factor directly related to the leverage used by the ETF. A 4x ETF is not illustrated because it does not currently exist in domestic markets.


The following table shows the effect of leverage. The exposure, gain, and loss values all assume the purchase of $10,000 of S&P 500–based ETFs using different amounts of leverage.

In crafting portfolios of securities such as ETFs, investors use leverage for many reasons. For example, investors may want to increase the efficiency of the use of capital, increase exposure when they aren’t able to borrow money on margin (as is the case in retirement accounts), or add volatility when the market is not providing it.

Let’s take the efficiency of the use of capital as an example. An investor who wants $30,000 of exposure to the S&P 500 could buy $10,000 of a 3x S&P 500 ETF and $20,000 of a short-term bond fund and earn a bit of interest on the bonds in addition to getting the desired exposure to the S&P 500. Many investment strategies require certain levels of market volatility in order to drive meaningful returns. Sometimes the market provides adequate volatility. However, when it does not, volatility may be added to a strategy by using leverage. A convenient way to do this is through the use of leveraged ETFs. For retirement accounts that cannot borrow money, it is one of the only ways to employ leverage.

Leverage has been used in economies ever since there were borrowers and lenders. Leverage in the securities industry is readily available and often used. Leverage is able to be carefully tailored to nearly any investment style and methodology. According to the 2017 “ETF Field Guide,” there are 127 ETFs that use (long) leverage. The following table shows how that total breaks down by investment category.

Use leverage with a purpose and an understanding of both the benefits and risks. Leverage should not be used simply because it is available. In other words, leverage in financial markets should be used with the same knowledge and care as leverage provided by credit in our day-to-day lives.

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned

 


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Everything in the newsletter pertains to strategies available on our Strategic Solutions platform at Trust Company of America. The same strategies are implemented on many other products: mutual funds, variable annuity, variable life and retirement platforms. Therefore, we expect the strategic discussion may be of interest to you. Note, however, that since these products have their own subaccount and fund universes and different internal expenses, the results and trading of the same strategy on other platforms may differ substantially from those described herein.

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