Surfing on the edge of a razor blade….another post in the Russian Roulette series.

For the retail investor, leveraged investment with high cost investment products is a bit like surfing on the edge of a razor blade: you either have an exhilarating ride of a lifetime or you end up crashing with all the ugly consequences.

What we should be aware of are that costs and timing are important, and so is the sophistication of the strategy, though neither are really given due consideration at the retail level.  As it is, recommending high cost, long term, leveraged strategies is like placing those investors on fast sledges at the top of mountains with no ability to break or manoeuvre.  

Importantly the ups and downs of the leveraged strategy are not symmetrical with the returns of the market so you can effectively bin the vast majority of risk disclosure.

In the following graph I look at the capital return and the total return on the S&P 500 since 1949 to the end of August 2013 – I have used the Shiller/Yale historical data set for this. 

Let us also assume leverage costs of prime + 1.25% and a mutual fund MER of 2.5% (but before net tax relief).   I have used the US prime rate as I have used the US market as the benchmark. image

The red is the capital return only profile and ends up with only 12 cents on the dollar (excludes impact of dividends and tax relief) and the blue line is the total return (includes dividends but ignores net tax relief) ending up with 98 cents on every dollar.  The capital profile is awful and the total return profile loses 2 cents on every dollar.  The long term picture varies depending on the cost structure and I think this is material.

But let us look at the blue line in more detail and let us work out what the average annual geometric return would have been if we had invested in any given month during this time period.

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Investing in August 1982 and in February 2003 would have generated marginal annual total returns.   Only from July 2008 and beyond would a leveraged investment strategy have produced viable annual returns.   But we should also be a bit nervous about this conclusion if markets, as many qualitative pundits suggest, is at levels likely to result in poor long term returns.   

Compare this to the same chart for the S&P 500:

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So let us compare the blue line total return in the first graph against the total return of the S&P 500:

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Or worse from the mid to late 1960s:

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The costs of leverage reduce the margin for error and timing is critical.  The downs and ups are not symmetrical.   What is more, buying at cyclical market and economic peaks has profound long term risks that no amount of “long term” can ameliorate.

But if we exclude the costs of the investments (0% MER) and take away any additional interest rate cost over and above prime (0% – the current margin interest rate for TD for direct accounts is prime + 1.25%), we get the following graph:

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Which translates into the following chart for annual geometric returns assuming each point on the graph is a starting point for investment:

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And here we can see that with just a prime rate cost of leverage and no other costs (before tax adjustments) leverage works out up till the latter part of the 1990s, works again during the subsequent bear market and recovery and beyond.   But this assumes a cost structure that just does not exist for retail investors and places a lot of faith in stability of investment returns going forward.  In fact, we could well be at a cyclical peak for market returns.  

So what would the above chart look like with a 25% correction for end August 2013 market levels?   A market correction would force even an unrealistic scenario to register a very poor return profile:

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And if we were to look at the return profile for a 25% market correction for a scenario with a 2.5% MER and Prime + 1.25%: not good is the answer.

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Costs matter, timing matters and the long term holds a multitude of sins.

In the end, high cost retail leverage investing is a bit like surfing on a razor blade.  Costs are important and so is the sophistication of the strategy though neither are really given due consideration at the retail level.  As it is, you are doing no less than placing investors in fast sledges at the top of mountains with no ability to steer, break or manoeuvre.  Either you end having an exhilarating ride of a lifetime or you crash with all the ugly consequences.

My guess is that regulators assessment of the risk/return trade-off of leverage assumes the prime cost only scenario and ignores the higher costs retail investors can expect with such strategies.

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