Leveraged investing part 1

Leveraged investing…Professional investors and companies use it to finance their business deals or boost returns of portfolio. Leverage can be a bitch to control in investment portfolio if it is used without thinking it through.

leverage-300x212 Leveraged investing part 1

High returns with increased risk

Leveraged investing can boost return of portfolio. As simple calculation example we manage to do winning trade with leverage.

Investor has 1000 dollars in investment account with margin contract. So he can use his/her portfolio as collateral for borrowed money.

Investor makes purchase with value of 2000 dollars which means he/she borrows 1000 dollars as margin loan. Next day account has balance of -1000 dollars and interest rate is charged for the negative balance. Let’s say yearly interest rate is 2% so for a day it is fraction of this = 2%/365 =0.005%

And with 1000 dollar loan it is 0.05 dollars.

If stock now rises 5%, investor score 10% return on own capital minus the interest rate payments.

But here is also the greatest danger using leverage. If stock goes down 5%, investor loses 10% of portfolio value. And if too much leverage is used, this decline might violate margin leverage limits and emergency sales by broker might be executed. This will further increases the loss in bear market.

Why leveraged ETFs usually fail in long term performance

With huge popularity of ETFs, also large number of leveraged ETFs have emerged.

Problem of leverage in market decline is the same as with stocks. Investor might be forced sell the position in panic and therefore lose any upside that might come later. Another problem is that these funds can quite tight leverage limits. Meaning if fund tell it has leverage of 2X it needs sell stocks in down market to keep leverage ratio from rising. Also in upmarket fund needs to take in more stock and leverage. So fund buys high and sells low. All investors know this is not beneficial in long term.

One additional problem is high fees that come from all the trades fund needs to do to manage the leverage. There might be some better and some worse leveraged ETFs but they are usually not recommended for long term investors

Leveraged investing in dividend portfolio with margin account (the right way to do it)

Using leverage with low leverage with dividend paying stock is my opinion the only right way to do it. When you are boosting dividends and not trading gains, risk is lower. Also dividend stocks usually are less volatile than growth stocks.

Example leverage:

Let’s say your margin account has leverage maximum of 2X.

own capital is 10’000 dollars

If we use for example leverage of 1.3X, our portfolio stocks value is 13’000 dollars.

If market goes down 45%, our leverage is

Portfolio position value 13’000X(1.0-0.45)=8’45

Net value=8’45-3=5’45

Leverage= 8’45/5’45=1.55X (still safely within the limit)

Expected return:

If our portfolio companies have average yield of 5% we would get also 1.3X( 6.5%)yield for our own 10’000 dollars.

However because we need to pay interest (e.g. 2%)on the loan, amount is lower

Effective return is 6.5% *(13’000)-2%*(loan amount)

For simplification we can first assume that loan part is 3000 dollar for whole year

With this simplification we get 845 – 60dollars =785 dollars or 7.85% on our 10k initially invested.

But actually theoretical return is higher because dividends eat away the loan and interest payments decrease with time. Other alternative is to reinvest these dividends and keep loan constant Or even reinvest dividends with 1.3X leverage. These two calculations will be done in next part where I show you how make “fever meter” to google spreadsheets for leveraged portfolios.

Read SEC info letter about margin accounts before starting:

https://www.sec.gov/investor/alerts/ib_marginaccounts.pdf

Keep on investing!

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