Russian Roulette: leverage and seeing through the marketing message…

How on earth are investors meant to be able to assess the risks and returns on borrowing to invest strategies when they are not provided with the hard data on which to assess the risks of their decision and when everything they read suggests only the unsophisticated are unable to appreciate the incredible benefits of leverage?

The following shows the annualised capital return on the S&P/TSX less an assumed annualised cost of margin/borrowing to invest of prime + 1.25% and less a mutual fund MER of 2.5%.  In other words, if you had leveraged in  July 2000, the annual net capital return would have been –6.8% to end September 2013, in February 2003, likewise –0.5% etc.   Dividends (which would be taxed) and tax relief would need to be added to this to assuage these risks.  But as you can see, these are not going to be sufficient for a great deal of the period assessed.

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Only those who leveraged briefly in the depths of the 2008/2009 downturn and more recently in late 2012 would be seeing a positive capital return to leverage investment.  I will provide a more detailed analysis in a later post.  

How on earth are investors meant to be able to assess the risks and returns on borrowing to invest strategies when they are not provided with the hard data on which to assess the risks of their decision and when everything they read suggests only the unsophisticated are unable to appreciate the incredible benefits of leverage?  So let us look at some excerpts from the marketing bumpf and the rather limp regulatory communication on the subject:

From a Manulife brochure: Each year, more and more Canadians are taking advantage of a simple yet powerful wealth creation strategy – investment leverage. For those unfamiliar with investment leverage, this strategy may sound a bit intimidating. But it’s actually quite simple.

Regulators seem to be fairly sanguine over the risks of borrowing to invest: the following is taken from the Ontario Securities Regulators document on leverage, and is not only the opening text, but is also arguably the most prominent text in the document:

Borrowing to buy mutual funds or other investments can be an effective way to boost your potential returns, but it involves more risk than paying for an investment outright with cash.

The following is taken from the same Manulife brochure:

“This break-even return depends on factors such as tax rate and interest costs (it isn’t important to detail the formula here) and, in Mike’s case, the break-even return is 5.43%.…the point to remember is that you generally don’t need huge returns for leverage to work…..In Mike’s case, his 5.43% break-even is well below the median 10-year return of 9-10% for Canadian equities…..Investment leverage can be a powerful strategy for accelerating your investment growth and helping you achieve your financial goals sooner. While this strategy involves an increased level of risk, much of the risk can be reduced with careful planning.”

Here is another excerpt from an Investors Group originated blog post (“This report specifically written and published by Investors Group is presented as a general source of information only”):

“William Shakespeare wrote Neither a borrower nor a lender be. And while Will was undoubtedly a great writer, he may not have been such great shakes as an investor – because for many people it definitely can pay to borrow for investment.…You are using someone else’s money to help you reach our investment goals….By dramatically increasing the size of your investment, you can also dramatically increase the potential for compound growth of your overall wealth……By investing the tax savings generated from the deduction of interest on your investment loan, you can significantly reduce your overall risk of loss. …Borrowing to invest is a proven investment strategy that can accelerate your ability to build a portfolio if you are comfortable with taking on debt and additional risk.”

There are clearly some issues with the above analysis:

First of all there is no breakdown of the actual costs of leverage: the costs of margin and or a bank loan is prime plus (usually) an additional premium.  In addition to this we have the transaction costs and also the management costs of investment vehicles.  Investors are unable to see the actual margins that are going to be left for them to pay off the debt.

- (Prime + x% ) – MER – Transaction costs – other costs + capital return + dividend return + tax relief = the net return.

Secondly, a lot of analysis supporting borrowing to invest is based on very long term stock market returns.  Looking at long term averages ignores the significant and quite often persistent periods of low to negative returns that occur in markets. 

According to the Credit Suisse Global Investment Returns Yearbook, from 2000 to 2012, the risk premium relative to bonds in Canada, was –3.2%, from 1963 to 2012, 1% and from 1900 to 2012 3.5%.    Also from the report:

To assume that savers can confidently expect large wealth increases from investing over the long term in the stock market – in essence, that the investment conditions of the 1990s will return – is delusional.

One thought on “Russian Roulette: leverage and seeing through the marketing message…

  1. Pingback: IIROC’s guidance for leveraged investment | Depth Dynamics

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