馃攳
Investing With Leverage (Borrowing to Invest, Leveraged ETFs) - YouTube
Channel: Ben Felix
[0]
- Investors who are
concerned about volatility
[2]
in their portfolio might add in
[4]
a bond index fund to
their asset allocation
[6]
in a proportion that matches
their risk preferences.
[9]
An allocation to bonds
reduces expected returns
[12]
but it also reduces expected volatility.
[14]
But what about investors
who are not concerned
[16]
with volatility and are willing
to take on even more risk
[19]
than the stock market
as a whole has to offer?
[21]
There are two options for these investors
[23]
reducing diversification
or using leverage.
[27]
I'm Ben Felix portfolio
manager at PWL capital.
[30]
In this episode of Common Sense Investing
[32]
I'm going to tell you how
leverage can boost your returns
[35]
and why it needs to be used with caution.
[37]
(upbeat music)
[40]
If you have committed to
being an aggressive investor
[43]
you might allocate 100%
of your investments
[45]
to a diversified portfolio of stocks.
[48]
If you believe in the
longterm positive returns
[50]
of the stocks and you're
comfortable with risk
[52]
you might want to get
even more aggressive.
[55]
One approach to getting
more aggressive is focusing
[57]
on only the riskiest stocks in the market.
[60]
Instead of buying a
total market index fund
[62]
you might find the 50 smallest
[64]
and cheapest stocks in the
market and only invest in those.
[67]
Remember a cheap stock,
[68]
a stock with a low price relative
[70]
to some fundamental measure
like earnings or book value,
[73]
is a stock that the
market is pricing as risky
[76]
leading to higher expected returns.
[78]
Reducing diversification has
some obvious disadvantages
[82]
it decreases the
reliability of your outcome
[85]
and it increases exposure to the specific
[87]
and uncompensated risk
[89]
of the relatively few
companies that you are.
[91]
Instead of building a
concentrated portfolio
[93]
a more theoretically sound approach
[95]
to increasing expected
risk adjusted returns,
[98]
would be building a well
diversified portfolio
[100]
and then increasing expected
returns at using leverage.
[104]
In a 2012 paper from AQR,
[106]
the author suggested
[107]
that most investors will choose
concentration over leverage
[110]
because concentration is more conventional
[112]
and feels less risky
[115]
but leveraging a well
diversified portfolio
[117]
actually leads to a
better expected outcome
[119]
than an increasing
concentration in risky assets.
[122]
The definition of well
diversified is debatable
[124]
lots of literature suggests
[126]
that even a total stock
market index fund is not well
[128]
diversified because it is concentrated
[130]
in a single risk, market risk,
[132]
adding in independent risks
[134]
like those of small stocks,
value stocks, profitable stocks
[137]
and other alternative risk premiums
[138]
might lead to a more reliable result.
[141]
For our purposes today,
[142]
let's assume that you have a portfolio
[143]
which you have deemed to have optimal risk
[145]
adjusted expected returns.
[147]
All right, let's talk about leverage.
[150]
Investing with leverage
means getting more exposure
[152]
to an asset, then the
amount of your own money
[154]
that you have invested in it.
[156]
Leverage comes in many
forms, including derivatives
[159]
but for now let's focus on
borrowing money to invest.
[162]
If you have $100,000 of cash to invest
[165]
in an optimal portfolio
[166]
and that portfolio returns
10% over some time period,
[170]
you will have $110,000.
[172]
If you took your $100,000
[174]
and borrowed another $100,000
to invest alongside it
[178]
that 10% return would
leave you with $220,000.
[182]
$100,000 of that is not yours,
[184]
but once you pay it back
[185]
you will still have $120,000
[188]
doubling your return from it 10% to 20%.
[191]
That sounds pretty good
[193]
but leverage has sort of an
evil twin on the downside.
[196]
In our example, a $10,000 loss
[198]
would turn into a $20,000 loss,
[201]
but a 50% loss would turn into a 100% loss
[204]
meaning that all of your money is gone.
[206]
All of these examples ignored
[207]
the cost of borrowing which is important.
[209]
If you make 10% with borrowed money
[211]
but it costs you 10% over
the same time period,
[213]
you've gained nothing.
[215]
The desire to borrow to
invest is not without basics
[218]
in a 2008 paper and again in a 2010 book
[221]
Ian Ayres and Barry Nalebuff
both professors at Yale,
[225]
argued that it is sensible,
[226]
even responsible for young
investors to use leverage.
[230]
The argument is based on the
fact that when we were younger
[232]
we tend to have much less cash to invest
[235]
but need to maintain lots
of exposure on stocks.
[238]
Even a young 100% equity investor
[240]
with only a few thousand dollars to invest
[242]
is allocating way less to stocks
[244]
than they optimally should
at that stage of their life.
[247]
The solution, as you may have guessed
[249]
is to borrow to invest in
stocks when you were young
[252]
and gradually decrease leverage over time.
[254]
This results in more
consistent exposure to stocks
[257]
through your investment lifetime
[258]
and as Ayres and Nalebuff demonstrate
[260]
a much better expected outcome.
[262]
This argument for using leverage
[264]
to gain time diversification
makes logical sense.
[267]
The longer that you
maintain exposure to stocks,
[270]
the more reliable your
outcome is going to be.
[272]
For a young investor with little to invest
[274]
using leverage allows
for increased exposure
[277]
to stocks early on.
[278]
Lots of people already do this
[280]
when they use leverage to buy a home
[281]
but it's a little bit
different with stocks
[283]
even with the possibility of total loss
[286]
for a young leverage investor
[288]
Ayres and Nalebuff explain
[289]
investors only face the risk of wiping out
[291]
their current investments
when they're still young
[294]
and will have a chance to rebuild
[296]
present savings might be extinguished,
[297]
but the present value of
future savings never will be
[301]
our simulations account
for this possibility
[303]
and even so, we find
that the minimum return
[305]
under the strategies with
initially leveraged positions
[308]
would be substantially higher
[309]
compared to the minimum
[310]
under traditional investment strategies.
[312]
All right, we have
established that leverage
[314]
is a sensible approach to
increasing your expected returns
[317]
and some literature even suggest
[319]
that it is the most responsible approach
[321]
for young investors building
wealth for retirement.
[323]
The practicalities of borrowing
to invest are important
[326]
lenders are more willing to lend you money
[328]
when they think you will
be able to pay it back.
[330]
The riskier that you look to a lender
[332]
the more they will charge
you to borrow money.
[334]
If you own a home outright
[335]
or at least with significant equity,
[337]
you can borrow against it
[338]
this is easily the cheapest form
[340]
of debt available in Canada.
[341]
The lender feels safe securing
a loan against your home.
[345]
You can use a home equity line of credit
[347]
or a traditional mortgage
to borrow against a home.
[349]
If you use a home equity line of credit
[351]
it is important to note
that the loan is callable.
[353]
The bank can change the terms
of the loan at any time,
[356]
even at a time
[357]
when your investments have
declined substantially.
[359]
If you don't own a home
with meaningful equity
[361]
the interest rate on an
unsecured line of credit
[363]
is probably going to be too high
[365]
for the purpose of investing
in a diversified portfolio.
[368]
The interest rate will likely be higher
[370]
than the expected return.
[372]
I don't think that I even need to mention
[373]
that using a credit card to
make a leverage investment
[375]
is probably not a good idea
[377]
but I mentioned it just in case.
[379]
If you have taxable
investments in a margin account
[381]
you can use a margin loan
[383]
which has a loan against the
investments in your account
[385]
to gain access to more capital.
[387]
Because the loan is secured
against your investments,
[389]
the interest rate will tend to be lower
[391]
than an unsecured line of credit,
[393]
but it is generally higher
[394]
than a home equity line of credit.
[397]
When you take a margin loan
[398]
you are exposed to the
risk of a margin call.
[400]
The loan is not allowed to exceed
[402]
some proportion of your account
[404]
depending on the assets that you own
[406]
say it's 50%, this means
that if you have $10,000,
[409]
you can borrow $10,000 on margin,
[412]
50% of your account a loan.
[414]
If the investments that you have used
[415]
to secure the loan decline in value
[417]
to the point that your loan
exceeds 50% of the portfolio
[420]
you will need to cover the difference
[422]
this is called a margin call.
[424]
If you don't have cash
to add to your account
[426]
to meet the margin requirement
[427]
the financial institution
may be allowed to sell
[429]
some of your investments to cover the loan
[432]
this scenario creates a downward spiral
[434]
of selling investments
that have declined in value
[436]
which is not ideal for obvious reasons.
[438]
In all of these cases of direct leverage,
[441]
it is possible to end up
in a net negative position
[444]
having nothing left in assets
and owning money to a lender
[447]
if your investments
declined below the value
[449]
of your invested equity.
[451]
One perk for this approach
to leverage investing
[453]
is that as long as you're investing
[454]
with borrowed money in a taxable account
[457]
with the intention of earning income,
[458]
the interest on the loan is
tax deductible in Canada.
[461]
Well limited access to cheap debt,
[463]
callable loans, margin calls
[465]
and the risk of a loss greater
than your initial investment
[468]
may be a deterrent to leverage investing
[470]
there are financial products
[472]
that have been designed to
overcome most of these issues.
[475]
Leveraged ETFS or ETFS that you can buy
[477]
without using leverage yourself,
[479]
they give you access to
a leveraged investment.
[482]
Take the ProShares ultra S and
P 500 ETF SSO as an example,
[487]
it is designed to deliver two times
[488]
the returns of the S and P 500.
[491]
The most important thing to understand
[492]
about leveraged ETFS is
that they are designed
[494]
to match the levered returns of an index
[496]
for a single trading day.
[498]
A long-term investor might not expect
[500]
the full amplification of returns
[502]
if they're holding it for
periods longer than one day
[505]
we're going to discuss this in detail.
[507]
Over a single trading day,
[508]
you expect to earn a multiple
[510]
of the underlying assets return.
[512]
If the index goes up 5%
[514]
your two X leveraged ETF should go up 10%.
[517]
The challenge comes when
the fund resets its leverage
[520]
at the end of the day.
[522]
Let's think through the process
of managing a leveraged ETF
[525]
if a leveraged S and P 500
ETF has $100 million in assets
[529]
it might invest $80
million in the S and P 500
[532]
and use the remaining 20 million
[534]
to enter into futures
contracts and swap agreements
[536]
to gain another 120 million
worth of exposure to the index.
[539]
This works perfectly on day one
[542]
say the S and P 500 delivers a 5% return
[545]
the fund will gain $10 million,
[547]
but on the next trading day
[549]
the fund has $110 million in assets.
[551]
Remember the total exposure to the index
[553]
was only $200 million yesterday
[556]
meaning that with $110 million in assets
[558]
the fund is no longer two X leverage
[561]
it has to use derivatives
to increase its exposure.
[564]
The result of the fund holder
[566]
is that they are buying more stocks
[567]
when the index increases
[569]
and selling stocks when it decreases.
[571]
Most importantly for a long-term investor
[573]
considering a position in a leveraged DTF
[576]
is that any volatile market,
[577]
the rebalancing effects of a leveraged ETF
[580]
could be detrimental.
[582]
This phenomenon has been examined
[583]
both theoretically and empirically.
[585]
In the 2010 paper path dependence
of leveraged ETF returns,
[589]
Marco Avellaneda and Stanley Zhang
[592]
suggest a formula that predicts
[593]
the relationship between
returns of an underlying asset
[596]
and the leveraged ETF tracking that asset.
[598]
The paper was in the
journal of the society
[600]
for industrial and applied mathematics
[603]
so I wouldn't get hung up
[604]
on trying to understand the equation.
[606]
But the relevant takeaway
[607]
is that there is a time decay associated
[610]
with the realized variance in the returns
[612]
of the underlying asset.
[614]
In the same paper the
authors empirically verify
[617]
that the expected time to K relationship
[619]
holds true in life leveraged ETF products.
[622]
The result for a long-term investor
[624]
is that you would not expect to achieve
[626]
the long-term leverage return
[628]
suggested by the name
of the leverage product.
[630]
This relationship can
work out in your favor
[633]
but it works against you
when the market is swinging
[635]
between positive and negative returns.
[638]
Another way to think about this
[639]
is that in addition to leverage exposure
[641]
to the underlying asset
[643]
a leveraged ETF investor
has negative exposure
[645]
to the variance in returns.
[647]
If variance is higher,
[649]
leveraged ETF returns will be lower.
[651]
The final point on leveraged ETFS
[653]
is that they come at a price
[655]
SSO has an expense ratio of 0.90%
[658]
10 times higher than an unlevered
S and P 500 ETF like SPY.
[663]
It is important to note
[664]
that I'm not saying that
leveraged ETFS are bad
[667]
they do deliver the
leverage return of an index.
[670]
The point of this discussion
is that they're designed
[672]
to replicate the daily leverage returns
[674]
of an underlying asset.
[676]
The ProShares webpage for SSO
offers a concise description
[679]
of why this might be relevant
to a long-term investor.
[682]
This leveraged ProShares
ETF seeks a return
[685]
that is two times the return
of its underlying benchmark
[687]
for a single day
[689]
as measured from one nav
calculation to the next.
[692]
Due to the compounding of daily returns
[694]
ProShares returns over
periods other than one day
[697]
will likely differ in amount
and possibly direction
[700]
from the target return
for the same period.
[702]
These effects may be more pronounced
[704]
in funds with larger or inverse multiples
[707]
and in funds with the volatile benchmarks.
[709]
Other than the time decay
that we've been discussing
[711]
there is research suggesting
[713]
that the easy access to leverage
offered by leverage ETFS
[717]
is priced into the asset.
[719]
In a 2011 paper titled embedded leverage
[722]
Andrea Frazzini and Lasse Pedersen
[724]
found that assets with
high embedded leverage
[726]
including leverage ETFS
have lower expected returns.
[730]
In other words the easy access to leverage
[733]
is priced into the asset
reducing its expected returns.
[736]
In summary, leverage ETFS will deliver
[738]
the daily leverage returns
[740]
of an underlying asset,
[741]
but their long-term buy and hold outcome
[743]
can be materially affected by volatility.
[746]
And some evidence suggests
[748]
that the embedded leverage is priced in
[750]
reducing expected returns
[752]
relative to a directly
leveraged investment
[754]
in the same underlying asset.
[755]
The practical challenges of
applying leverage to a portfolio
[758]
that we've discussed are
only the tip of the iceberg
[761]
the real challenge is behavioral.
[764]
We know that most
investors are badly behaved
[766]
at the worst possible times.
[768]
This is why many people allocate
[769]
a portion of their portfolio to bonds
[771]
it helps them to stay invested.
[773]
Being a 100% equity investor
[775]
is behaviourally risky for many people
[777]
and leverage is going to
amplify that behavioral risk.
[781]
There are some pretty good arguments
[783]
that leverage is useful in building wealth
[785]
as long as you can stay invested
[786]
even after a total wipe out.
[788]
If you do apply this strategy
[790]
whether through direct
leverage from a loan
[792]
or embedded leverage
in a financial product
[794]
I suggest that you proceed with caution.
[796]
Thanks for watching
[797]
my name is Ben Felix of PWL capital
[799]
and this is Common Sense Investing.
[801]
If you enjoyed this video
please share it with someone
[804]
who you think could benefit
from the information.
[806]
Don't forget if you've run out
[808]
of Common Sense Investing videos to watch,
[810]
you can tune into weekly episodes
[811]
of the rational reminder podcast
[813]
wherever you get your podcasts.
[815]
(upbeat music)
Most Recent Videos:
You can go back to the homepage right here: Homepage