Getting Killed By Leverage

Yesterday’s article on leverage sparked conversation. It’s the conversation that’s always sparked by leverage because you invariably have to say that “it works both ways.” Andrew Tobias pointed that out in his inestimable The Only Investment Guide You’ll Ever Need.

Wade asked:

If the index falls 50% and you are leveraged 100%, don’t you lose everything?

With most investments, yes. With leveraged mutual funds and ETFs, however, no. The reason is that they maintain constant leverage by daily rebalancing of equity and debt, whereby they buy shares when the market rises and sell when it falls. Even though they are selling shares by the boatload as the market plummets, they’ll always have some shares leftover.

The main point, though, is whether you can be severely damaged by a leveraged index investment in the event of a big bear market and the answer is: absolutely. This is their downside.

However, can’t we say the same about any investment? If you bough Sharper Image for $13 last June, you’d be in bad shape now. It closed at $1.81 yesterday.

Tom wrote:

If we start looking at your example from another date, the results would be very different. Let’s say I had invested $10,000 on April 1998, at the start of a short bearish period:

04/98 to 08/98: -50%
08/98 to 08/00: +186%
08/00 to 03/03: -59%
03/03 to 04/06: +220%
04/06 to 07/06: -23%
07/06 to 10/07: +55%

This gives me a return of only 8.86% per year for the past 9.5 years, well below many actively managed funds. Am I calculating this right?

Yes, Tom is calculating right. The unfortunate person who started their investment program in April 1998 is still waiting to see much success.

Is it really the fault of leverage, though?

The total return of the leverage in the period Tom specified was 124%. During that same period, the total return of the Dow was 53% and the Nasdaq 45%. That gives them respective average annual returns of 4.6% and 4.0%.

As for how 8.86% per year since April 1998 stacks up against mutual funds, according to Morningstar, it makes the top quartile. That’s pretty good considering that Tom deliberately chose one of the worst times to have begun the investment program.

Both Wade and Tom make valid points. Any leveraging strategy has the downside of magnifying losses. It’s possible to time it just wrong and do lousy. Any measure that can be taken to reduce the steep losses helps immensely. We can’t count on that skill, however, so I leave it out of my calculations and always include full losses with full gains.

My own ability to time the market has proven to be pretty good, which is why I’ll be launching a timing service around these leveraging strategies next year. My hope is to add value by reducing the impact of down markets by being in cash during a portion of them.

A simpler approach is to only use this leverage after the market has corrected at least 20%, or to double your regular contributions to the portfolio during such corrections. Setting a concrete percentage on the decline required to use leverage removes the need for intuition, which is unreliable.

I’ll show the benefit of using set percentage levels to change your contribution in a future article.

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One Comment

  1. randy hobbs
    Posted September 5, 2010 at 11:31 am | Permalink

    Thanks for the opportunity to ask a question. As regarding the Leveraged ETF’s like MVV, SSO and TNA how safe are they long term within their management team. What I mean by this, does it buy in the index with futures and other leveraged derivatives according to the equivalent to ‘the index itself.’ For example, one of the Vanguard funds mirrors the S&P 500. In other words, if the benchmark rises 1% for the day the Vanguard funds does the same. My concern is, can the leveraged etf fall victim to human error? or is it based totally on what that sector is performing at? The reason I ask this question is that I may wish to look long term as in 10 years and perhaps until torward the end of a future bull market possibly in 2020 or even 2025. I am aware of the volatility and how it can affect the return in a sideways market. Regards, Randy Hobbs, Australia.

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