What is wrong with leveraging?

I was pleased to see the heading on the Financial Post article, “What is Wrong with Leveraging”, but upon reading found that the article did not provide an argument against leverage.  It was an argument against people using their investments to pay the interest costs of the exercise, rather than against leverage per se.  

Most investors do not understand the risks of leverage: transaction, management and other costs of the underlying investment vehicles and services risk wiping out the additional return from a leveraged investment, leaving the investor with the risk and the financial advisors/institutions the return. 

You do have to ask yourself why you are being provided with the loan in the first place!  It is worthwhile remembering that there is the loan interest return, the commission and transaction returns, the service cost returns and the security selection and management return for non indexed strategies.  These returns have greater certainty than a leveraged asset’s returns.

Yes, historically, depending on the time frame selected, total returns on equities may well have outperformed the costs of leverage, but this margin can often be slim and, for long periods of time, adverse.  

Of great concern is the impact of cyclical and structural valuation risks on future returns from leveraged strategies.  From the 1980s to the end of the 1990s, falling interest rates and rising risky asset prices provided a rationale for leverage, for many – this trend however, has more or less reversed in the 2000s, and onwards, if the future is about lower asset returns, then leverage will remain a very high risk and at times deadly sport. 

People will also argue that leverage is a fact of life, that companies borrow to invest all the time and that most people do so to buy property.   There are problems with this type of thinking:

  1. When you own shares these may already be leveraged: the return to shareholders in a company is after the costs of financial leverage has been taken into consideration; earnings, from which dividends are paid, and on which share prices are based, are after tax and after borrowing costs.  An investor who leverages their equity allocation is adding a further layer of costs and a further layer of risk.   You are preferring to skate where the ice is thinnest, taking risks that not even the underlying assets deemed prudent to take.
  2. Most people who borrow to buy property, because they are swapping a rental cost for an interest cost are not taking a similar level of risk – while both bear the capital risk of the loan, the comparable risks of the two transactions are different.     

Many professional investors will attempt to use leverage to enhance returns.   While history is littered with leveraged wealthy investor vehicles that have hit the rocks, those that are successful depend on their ability to time the market, to buy assets at cheap prices, leverage up and then offload assets and reduce leverage at higher valuations. 

Successful leveraged strategies do not maintain their leverage at a constant level throughout the market and economic cycle and they play close attention to risks.   They may also hedge the risks they are leveraging, looking more for secure marginal returns, strategies that most retail private investor do not employ.

Most leveraged strategies in the Canadian retail financial services market place are likely to be anything but sophisticated.  They are recommended by advisors with limited expertise and an alternative financial interest, and they will often at times use products whose costs mitigate those benefits available to the investor.  

I know modern portfolio theory and the human capital arm of MPT have a theoretical framework in which leverage may have a place, but this assumes that markets are efficient and that demand and supply are in equilibrium, amongst other simplifying and unrealistic assumptions.  

The real world has risks that are at odds with these models and costs that would obviate the rationale even in a theoretical world.  If an asset is worth leveraging it should be mispriced by the market, which means that there are risks attached to the price that need to be addressed before validating the strategy. 

Leverage may have a place in a competitive market place so that demand and supply imbalances can be brought into balance, but this is not what leverage is used for in the retail market place. 

Anybody who wants to understand the perils of leveraged investments should read Re Gareau – document 1, 2.

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