In their scramble to secure a foothold on an increasingly unaffordable housing ladder, some young investors might be looking for new ways to boost their returns on savings.
One such approach – albeit highly risky – is “leveraged investing”. In simple terms, this means borrowing money to invest.
Holding a mortgage is itself one way of doing this. This is because the relatively small deposit you pay to secure the loan exposes you to the capital gains (or losses) on an entire property as prices go up (or down).
Borrowing to invest in other assets is less common. But large corporations do it all the time. There are ways for individuals to do it too, including with relatively new financial products called “geared exchange-traded funds”.
So how do individual investors currently take advantage of leverage in the share market – and what might the risks be?
Margin lending
On face value, the mathematics of borrowing to invest might seem simple and alluring.
If an investor can borrow at an annual interest rate of 9% to invest in an asset with an expected annual return of 15% – and if those expectations are actually realised in the market – they get to pocket the excess of 6% (minus any fees).
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The traditional method for borrowing to invest is called “margin lending”. A lender, such as one of the big four banks, lends money to an investor which they then invest in the stock market.
The amount lent is typically determined by the amount of collateral an investor can produce to secure the loan.
For example, using a common loan-to-value ratio of 70%, an investor with a diversified portfolio of shares worth $20,000 could borrow an additional $47,000 to invest in the stock market.
This would give them a stock market exposure of $67,000 in total. But in return, the investor would have to pay interest on the loan.
If the stock market declines so much that the loan-to-value ratio falls below the lender’s minimum requirements, the investor will also have to cough up some additional capital as collateral. This is what’s known as a margin call.
Margin lending isn’t uncommon in Australia. Recent figures from the Reserve Bank of Australia show that in the March quarter this year, more than $15.8 billion was loaned across 80,000 client accounts in Australia.
In that same quarter, there were 367 margin calls made. Margin investing requires a bit of ongoing attention, and carries with it an administrative burden that many retail investors would be keen to avoid.
Greater exposure to the whole market
An alternative method of leveraged investing is to invest in a geared exchange-traded fund (ETF). These are relatively new on the scene.
ETFs are financial products that bundle together a wide range of investments into a single offering that can be bought and sold on a stock exchange. For example, an ETF might track the movement of stocks in a major index or companies in a particular sector.
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A geared ETF, like a margin loan account, will have a target loan-to-value ratio that looks to boost returns from an investment. But it’s a professional fund manager doing all the borrowing.
An individual investor in a geared ETF will just see higher peaks and deeper troughs in price movements than a non-geared equivalent.
Promoters of these funds suggest that two key features provide clear advantages over traditional margin loans.
First, because of their size, the funds can borrow money to invest at institutional interest rates. These are expected to be lower than the rate applicable to individual margin accounts.
Second, there are no margin calls for individual investors. Instead, if the value of the investment falls enough to make loan-to-value ratio unacceptable, the fund sells down some of its assets to bring down its level of debt.
What could possibly go wrong?
A lot. All investing comes with a level of risk. Borrowing to invest adds a whole new level. Here are some of the biggest factors to be aware of.
First and foremost, leveraged investing can magnify gains – but it can also magnify losses. The extra volatility of these strategies means sharp market movements can quickly wipe out much of an investment. This is true for both margin lending and geared investment products.
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And while returns are uncertain, the interest on debt is not. Regardless of whether the market is up or down, whether the investor has borrowed on their behalf or a leveraged ETF has done it for them, interest has to be paid on the debt used.
This can weigh heavily on a portfolio’s returns, and when markets are down, further amplify losses.
One further risk is unique to ETFs – tracking error. This arises when their returns don’t “track” the returns from the benchmark indexes they’re supposed to be imitating.
Everyday ETFs manage this error by continuously buying and selling assets to “rebalance” their portfolios. But leveraged ETFs have the additional task of buying and selling shares in a falling market to maintain their target loan-to-value ratio.
This additional drag on returns is referred to as “slippage” and has been identified by regulators as an extra risk retail investors should be aware of before considering investing in leveraged ETFs.
Does leverage provide the opportunity to magnify stock market gains? The answer is yes, but not without a cost that many may find unbearable if markets happen to move against them.
And it’s important to note that our discussion here is only very general in nature, and is not intended as financial advice. All investments carry risk.
