Leverage- A Good Idea or a Dangerous Risk?

With interest rates at historically low levels, investors may wonder if they are leaving money on the table by not taking advantage of their ability to borrow and invest in the market. Simply put, as long as the rate of return exceeds the interest rate on the loan, then the gambit will be profitable, and conversely. To determine how a leveraged investor would have done over the last 15 years, IFA performed a simple study based on the annual returns for IFA Index Portfolios 90 and 100 as well as the US Total Stock Market. We made the generous assumption that our hypothetical investor could borrow the full value of his account at 4%. The results are not encouraging. The use of leverage substantially lowered the annualized return and essentially doubled the volatility (standard deviation) of the portfolio. The results are summarized in the figure below:

(click to see enlarge the chart)

The underlying reason for these sub-optimal results is not difficult to understand. The use of leverage amplifies the returns of the market, and when the market has gone down, the amplification of the negative return creates a hurdle that is difficult to overcome. For example, in 2008, our leveraged investor in the total stock market absorbed a loss of 78%. To make himself whole, he would require a gain of 355%! While it is true that other time periods show a higher return for leveraged portfolios, the much higher standard deviation is invariant, and very few (if any) investors have the ability to endure that level of volatility.

Clearly, Leverage is one of those strategies that works great until it stops working (and leaves you high and dry). IFA’s recommendation is to avoid borrowing for the purpose of buying securities on margin, even at a generously low interest rate. Furthermore, IFA counsels investors to avoid investments that employ leverage such as leveraged and inverse ETFs, hedge funds, and REITs that invest in mortgage backed securities (e.g., Annaly Capital Management was leveraged at a ratio of 7.31:1 as of 6/30/2011, according to Morningstar).