“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive,” Buffett said in 2010. “Once having profited from its wonders, very few people retreat to more conservative practices.”
Buffett’s folksy investment advice is, as always, memorable, sensible, and, in this instance, sweeping.
On the one hand, Buffett’s admonishment continues to be relevant to retail investors because using borrowed money to magnify returns could easily go south and crater a portfolio.
On the other hand, Buffett’s success was built on leverage. Specifically, borrowed money from the insurance arm of Berkshire Hathaway.
A well-publicized study, Buffett’s Alpha, in 2013 concluded that:
“In essence, we find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.”
Some commenters pointed out that his returns would not have been as spectacular without his use of leverage – which played an important part in his early years at Berkshire. See The Secrets of Buffett’s Success in The Economist.
Notwithstanding, these analyses do not diminish Buffett’s stroke of commercial and investing brilliance:
- Founding an insurance entity which yielded a steady cashflow (in the form of insurance premium from clients);
- “Borrowing” against this secured “line of credit” (from his insurance arm to his investment arm);
- Ready access to this inexpensive loan (leverage) to purchase high-quality stocks; and
- Beating the market to generate outsized returns for his investors.
Now that we are better able to appreciate the type of leverage that Buffett created and had access to, we need to recognize the leverage available to most retail investors.
Which, truth be told, is crappy.
Most individual investors have to use margin loans which typically carry an interest rate of 5 percent or higher; these margin loans almost always include terms that allow the lender to force a borrower to repay the loan at a moment’s notice. In other words, such loans are callable.
What options remain for an investor to be as savvy as Buffett to beat the market?
First, access good leverage; and second, apply the leverage prudently.
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Unwise use of leverage
Leverage, simply put, refers to using borrowed money to invest in order to boost returns.
For example, you have $100 to invest in stocks. You borrow an additional $100 from your broker to buy $200 worth of stocks.
If the stocks you purchase go up in value by 10 percent, you will make $20 (or 20 percent on your capital); rather than just $10 if you had not borrowed (not factoring in the cost of borrowing).
Similarly, a drop in the value of the stocks by 10 percent results in a painful loss of 20 percent of your portfolio.
In a nutshell, leverage is a double-edged sword that could amplify profits as well as losses.
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Now, consider an investment in the broad equity index S&P 500 via SPY (SPDR S&P 500 ETF Trust).
A naïve investor might wish to double one’s returns by borrowing 100 percent of one’s trading capital and investing both capital and borrowed funds to buy SPY.
If one had started using this investment approach in 1995, one would be very pleased with the performance in the first five years – the portfolio increased by more than six times (or 600 percent)!
Source: AQM research
However, during the dotcom crash in 2002, the market drawdown was a whopping 44.7 percent – this meant that a two-times leveraged portfolio would experience a theoretical loss of more than 80 percent.
In reality, our hypothetical investor would receive a margin call from his/her broker way before he/she lost 80 percent of capital. In addition, the investor must pay for the cost/interest associated with the borrowed fund.
Even if the investor was willing to answer the margin call, topped up his/her account and maintain his/her leverage position in 2002, the subprime crisis in 2008 would have wiped out the investor’s account as the portfolio would have suffered a theoretical loss of more than 100 percent (50.8 percent x 2).
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Measure risk-adjusted return
The amount of leverage that an investor could apply is highly dependent on expected maximum drawdown of the investment strategy adopted.
To be precise, an investor should always aim to optimise one’s return-to-risk ratio which is obtained by dividing CAGR by maximum drawdown.
Such a ratio provides an objective metric to measure the performance of different investment strategies and instruments.
Basically, it measures how many units of annualised returns an investor might expect to gain for each unit of capital he/she is willing to put at risk.
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To illustrate the difference between absolute return and risk-adjusted return, let us consider the performance of two instruments: An ETF that tracks the S&P 500 (SPY) and another ETF that tracks the 7-10 years Treasury Bonds (IEF).
Clearly, SPY outperformed IEF from an absolute return perspective as SPY produced a CAGR of 11.0 percent compared to 4.6 percent offered by IEF.
However, comparing both instrument’s return-to-risk ratios, we observe that IEF is a superior product: IEF has a ratio of 0.61 (11.0/50.8) while SPY has a much lower ratio of 0.22 (4.6/7.6).
Observe that IEF’s return-to-risk ratio is almost three times higher.
The implication is: If an investor, in theory, were to borrow 200 percent of his/her investment capital and invest all 300 percent of the fund in IEF, he/she could expect returns comparable to SPY (not accounting for cost of borrowing) but drastically reducing the portfolio drawdown by more than half!
In summary, risk-adjusted return matters.
Source: AQM research ___________________________________________________________________
How to use leverage to beat the market
Leverage is a powerful tool. If used correctly, leverage could help investors boast returns and beat the market.
However, before making any attempt to beat the market using leverage, it is essential to fulfil the following prerequisites:
- Access investment strategies with a high return-to-risk ratio: The higher the better. Apply a rule of thumb that the ratio must be at least higher than that offered by market benchmarks, say the S&P 500.
- Access leverage with favourable terms: Borrowing an unsecured loan from a bank to invest is an example of a lousy approach.
Let’s walk through an example of how to achieve these prerequisites and implement a strategy to outperform the market.
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Constructing a simple high risk-adjusted portfolio
Before making leverage investments, it is crucial to access an investment strategy with a higher return-to-reward ratio compared to the broad equity market.
Start with a simple, diversified portfolio of 50 percent equity (SPY), 30 percent bonds (TLT), and 20 percent gold (GLD) which is rebalance monthly.
Bonds and gold are relatively uncorrelated with equity and serve to reduce both volatility and drawdown of an overall portfolio.
Backtest of this simple portfolio produces a significantly lower maximum drawdown and higher return-to-risk ratio of 0.43 compared to 0.20 offered by SPY.
Source: AQM research
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Use of leveraged ETFs
Instead of borrowing funds from a broker, consider a leveraged version of the above strategy using leveraged ETFs.
A significant advantage of using leveraged ETFs is no margin calls from a broker during portfolio drawdown nor interest payment on borrowed funds.
Similar to the “borrowing” used by Buffet to invest in stocks, an ETF as “debt” is not callable and comes at a low cost.
To achieve leverage, replace SPY, TLT, and GLD with the following leveraged ETFs:
- SPXL – Direxion Daily S&P 500 Bull 3X ETF
- TMF – Direxion Daily 20+ Year Treasury Bull 3X ETF
- UGL – ProShares Ultra Gold 3X ETF
Because these ETFs offer three times leverage to investors, it may not be wise to invest 100 percent of our trading capital in these leveraged instruments – as the corresponding, amplified losses during a market downturn will likely be too much to stomach for most investors.
To limit drawdown risk, consider investing 70 percent of trading capital in these ETFs. Thus keeping the relative composition the same as before.
Hence, capital is allocated as follows and rebalanced monthly:
- SPXL: 35% (70% x 50%)
- TMF: 21% (70% x 30%)
- UGL: 14% (70% x 20%)
- Cash: 30%
Backtest of this leveraged portfolio shows a higher CAGR of 18.9 percent compared to the 14.6 percent offered by SPY.
Yet with higher CAGR, the leveraged portfolio suffers a lower maximum drawdown and enjoys a higher return-to-risk ratio compared to SPY!
A key takeaway is that the use of leverage does not inevitably translate to risky investments.
On the contrary, if used prudently, especially applied to high risk-adjusted investment strategies, leverage can be a powerful tool to help investors beat the market.
Source: AQM research
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Conclusion
This simple ETF strategy illustrates that leverage, applied prudently, can be a useful investment tool.
AQM is one of many emerging investment strategy firms that specializes in the trading of ETFs to beat the market. This involves sophisticated trading models, stringent ETF selection, and rational use of leverage.
From an investor perspective, our clients value funds that offer high, risk-adjusted return – not simply high, absolute return.
In particular, informed investors ought to be wary of funds that chase high returns with leveraging investment strategies and little regard for quantifying risk.
As mentioned in an earlier post, a risk-adjusted return lens is a useful way to filter out many supposedly high-performance funds.
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Further readings: More about how leveraged ETFs work here and a cautionary tale about unsophisticated use of leveraged ETFs here.
