Leverage: A Primer

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive!

Some of my readers (and podcast listeners) have been waiting for this article for a long time. Today, Markus and I finally deliver.

Let’s talk about the wonderful, yet misunderstood, topic of financial leverage. 

Among retail investors, leverage is typically seen as a ‘get rich quick’ scheme. Buy a structured product giving you 100x exposure to Tesla, orange juice futures, or even more niche opportunities - and then either buy a Lamborghini tomorrow, or face yourself with a 100% loss. If you’re a slightly more sophisticated retail investor, you might use a strategy based around a levered ETF, like the so-called Heiliger Amumbo (an Amundi ETF providing you with 2x exposure to the MSCI USA). Which works well until a sudden, hard crash, like the one we saw after Liberation Day in early April.

But affluent investors, surprisingly, don’t tend to be much more sophisticated about their use of leverage. They might use options and structured products as a way to get leverage for tactical ideas that are either identified by the investors themselves or proposed to them by their private banker. Or they use portfolio-level leverage (like margin loans) to create liquidity without having to sell investments. Less frequently, said margin loan is used to increase long-term target returns, but often in ways that might actually be less than ideal.

So today, let’s give you an introduction into the wonderful world of portfolio leverage. Best practices, mathematical examples, and of course some practical advice. Let’s dive in!

Disclaimer: The information in this newsletter is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities (keine Anlageberatung oder Anlagevermittlung). Any financial products mentioned in this article are solely named for illustrative purposes. We explicitly do not endorse the use of leverage. The use of leverage is speculative and involves a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, that may exceed the amount that you initially invested. Search for expert advice before you consider leverage. Historical performance is no indicator for future returns.

Why (and how) to use leverage

We’ve outlined a number of typical reasons to use leverage, both among retail and affluent investors. We can summarize them in one simple sentence: Leverage is (typically) used to boost long-term returns. What people pay less attention to is that leverage doesn’t come for free - figuratively and literally.

Leverage increases returns, but also increases risks. If you have 100€ (“equity” in your personal capital structure) and take on 50€ of leverage (“debt” in your personal capital structure), you are now exposed to 150€ of whatever you invest that capital in. And if looking back to your equity, i.e. your actual capital, you are now exposed to volatility on 150€, and not 100€, of capital. That can go well, but of course, can also not go so well. If your investments go down to 100€ (i.e. a 33% drop), you are still on the hook for 50€ of debt, meaning that your equity is seeing not a 33% but a 50% drop in value.

And secondly, as mentioned above, leverage does not come for free. In the case of portfolio leverage, like a margin loan, you have to pay interest. When you buy derivatives, like futures or options, you lock in the expected financing costs over the term of the contract. In the case of futures, the interest costs are embedded in the projected price of the underlying. With options, you pay the option premium, which stands at the risk of being forfeit if your options don’t end up in the money. The earlier-mentioned leveraged products (like structured products or the fabled Amumbo) make use of one of those forms of leverage, and also have to pay for them, even though not directly visible to you.

In the end, leverage is not per se a bad thing. As with most financial instruments out there, it simply needs to be used in a diligent manner. If done correctly and through the right instruments, leverage can be a way to build higher-return portfolios with better risk-reward-ratios than stocks, or can provide flexibility to investors in regards to their liquidity management.

But more on that later. Let’s first talk about what some of you might have come for: Our honest view of levered ETFs. Like the Amumbo.

Levered ETFs: The Facts

Let’s cut to the chase: We don’t think that levered ETFs are an ideal instrument for accessing leverage, and thus higher expected returns, in your portfolio.

First, there’s high costs. Depending on the product, the running costs of the ETF start at 0.50% and tend to be higher, especially for short-term tactical products. In addition, and what is often not made transparent or easy to find, are the financing costs. In the case of the Amumbo, a so-called Swap contract is being used: The ETF itself holds stocks and the performance of these stocks is “swapped” against that of the 2x MSCI USA index, minus financing costs. Those financing rates are not easy to find or estimate. Additionally, for this service the swap provider is paid a fee, too. Looking at past performance of the Amumbo, we estimate financing and swap costs at around 2.0-2.5% p.a. (on top of the official short-term financing rate).

Secondly, there’s the so-called volatility drag. If a product goes up by 1%, and then down by 1%, you don’t get back to 100%, but slightly lower than its starting price. When using daily leverage, this effect is pronounced even further, which can be particularly harmful in a market crash. But also in a sideways market environment, your investment can slowly wither away, when the average daily market return (potentially due to costs) moves close to zero or even into slightly negative territory for longer periods of time.

Third and last, and perhaps the most important one to us: Path dependency. Most readers might want to use the Amumbo or other levered ETFs to boost the return on assets that they allocate for their retirement. Typically, such investors are blessed with a long-term time horizon, meaning that they can sit out drawdowns in the equity markets, or might even benefit from them through dollar-cost averaging. But if substantially levered, drawdowns aren’t an opportunity, but a substantial risk, where a 30-50% drawdown (not unheard of in markets historically) might quickly wipe out 90-99% of your entire portfolio. Worth it for a tactical trade, perhaps, but not for your retirement money.

Levered ETFs: The Figures

As promised, we want to provide you not just with our opinion, but also a thoughtful, quantitative analysis. That’s where my dear co-founder Markus’s analytical skills come in.

To get as close as we can to the Amumbo, let’s use the S&P 500 as a long-term index on which we conduct our analysis. We start in 1954 and compare the unlevered S&P 500 (including reinvested dividends), as well as a 2x and a 3x daily leveraged version. We assume a TER of 0.50% p.a. (in-line with existing products), and assume a 2.5% funding spread (as estimated from Amumbo’s live track record).

Our analysis shows the following:

Hypothetical performance chart and statistics of the S&P 500 index with dividends reinvested compared to 2x and 3x daily levered versions (indexed at 100, 31/12/1954 - 31/12/2024, in US Dollar, log-scaled)

Sources: Bloomberg, LSEG Refinitiv, Amundi, MSCI, S&P, Cape May Wealth Advisors. As of 31/12/2024. For educational purposes only. Return and volatility statistics are based on annual returns data to avoid unwanted smoothing, while max. drawdown is based on daily data points. No costs are considered for the index, while the levered versions incur a 0.50% expense ratio as well as a 2.5% funding spread over the Effective Fed Funds Rate. Due to data availability, from 1954 to 1998, index performance is based on the S&P 500 (price) index adjusted for reinvested dividends based on average long-term dividend yield estimates; that performance may significantly deviate from the S&P 500 total return index, which is used from 1999 onwards. You cannot invest directly in an index. Past performance is not a guarantee of future results, which may vary. The value of investments and the income from investments will fluctuate and may go down as well as up. Loss of capital may occur.

I have to admit, the numbers were surprising to me. Despite a higher annualized return since inception, the 2x leveraged version just barely achieved the total return of the unlevered version. The 3x leveraged version did even worse - which brings us back to volatility drag: While all three examples saw their maximum drawdown in the depths of the Global Financial Crisis (March 2009 to be precise), the S&P 500 made a return to all-time highs later, as did the 2x levered version. But not so the 3x levered version, which lost more than 99% of its value from its Dotcom peak, and barely recovered to pre-2009 levels. Since 1999, for both the S&P 500 and more so European markets (using the MSCI Europe), both levered options actually would have done noticeably worse based on our analysis, given the lower longer-term performance relative to previous decades.

Or to put numbers into words: Levered ETFs only do well when the underlying asset can achieve high returns over long timeframes, which can offset the massive drawdowns in market corrections. Markus was personally surprised to see how well the levered versions can recover even after a >90% drop in value. But if those long periods of high average returns are not given, levered ETFs lose their appeal. If long-term returns are even modestly lower (i.e. due to an increase in funding costs or lower expected returns due to macroeconomic developments), the aforementioned volatility drag starts to impact you more severely. Or to give you another example: Had the S&P 500 seen just a 1.5% lower average return p.a. (which still equates to an impressive 10% p.a.), the 2x leveraged product would’ve never managed to catch up with the unlevered version since 1973.

Fans of the Amumbo say that simple risk management techniques, such as moving averages, can be used to avoid those drawdowns. While that might indeed work for slower, more pronounced market developments, we question whether this gives you sufficient protection in the fast, strong corrections that we’ve been seeing in the last years (such as COVID or the Liberation Day). In such cases, the sell-signals might only be triggered after you already suffered the majority of losses and then potentially leaves you uninvested if the market quickly recovers. One such poor market-timing can leave investors with losses that can substantially impact long-term (possibly multi-decade) returns. And of course, such risk management necessitates that you actually monitor your signals on a regular basis, which is much more involved than a simple ETF savings plan.

To be clear: Levered ETFs aren’t per se a bad instrument. They may simply be a more tactical than long-term investment. But we at Cape May aren’t looking to do tactical trading or traditional active management. In all we do, we are looking for long-term strategic options that can enhance returns and/or reduce risks (see The Search for Structural Alpha). 

So what are our strategic, long-term options when it comes to leverage?

Markus and I regularly assist our clients at Cape May Wealth Advisors in assessing how they might use leverage in the context of their personal situation. Frequent questions include, but aren’t limited to:

• Leverage in the context of their personal residence. Should I buy my dream home with cash on hand, or should I take on a mortgage? And if using debt, how does the ongoing mortgage payment (but also additional investable capital) affect their long-term return requirements?

• Leverage as a cash management tool. Should I sell assets to fund my personal lifestyle, or does it also make sense to do so through leverage? How about using leverage as a tool to reduce my liquidity buffer in the ‘Safety Bucket’? To what degree should I use leverage to diversify into riskier, illiquid assets?

• Leverage as a way to boost returns. Can leverage be an instrument to boost the long-term return of my liquid portfolio? If so, what is the right instrument for me - and how does it affect my overall risk-return metrics?

We’d be happy to assist you with all those questions, and regularly work with partners that can provide you with specific debt solutions in the context of your portfolio, your personal residence, and other areas of your life. If you’re interest, don’t hesitate to reach out.

Better Ways to Lever Your Portfolio

Let’s start with leverage outside of financial products - loans.

In the financial context, the most common option to lever your portfolio is a margin loan. Margin loans are secured with your investment portfolio, and are subject to variable interest rates. They might either act like a revolving credit line, meaning that they have no fixed due date at all but stay outstanding until repaid at your convenience, or in some cases might be taken on as a loan with a fixed term (i.e. a month to a year).

Especially to the benefit of affluent investors, margin loans are a very flexible product. Depending on the investments that you provide as collateral, your loan-to-value ratio (i.e. what percentage of your portfolio can you take out as a loan) might be quite high, ranging from 30-50% for large-cap stocks to 70-80% for a diversified ETF portfolio. Interest rates are typically also on the lower end, typically priced at a spread of ~1% over the relevant reference rate (like Euribor or SOFR). 

The flexibility of a margin loan can also be their downside. If you end up with securities valued at less than what is required by the bank/broker (a “margin call”), you typically only have very little time (48-72 hours) to pay back the loan and/or to provide additional capital. If you can’t fulfill that obligation, the bank might liquidate your assets regardless of whether it is a favorable price or not, and you might even be on the hook for any remaining liabilities.

You can also lever through traditional loans. They might be secured through hard/financial assets provided as collateral (i.e. real estate), but might also be unsecured (i.e. provided based on your general creditworthiness). However, they tend to be much more expensive than a margin loan, and are typically subject to a fixed repayment scheme. 

Whether it’s advisable for you to lever hard assets to invest in financial assets, or vice-versa (i.e. taking out a margin loan to pay a capital call) - that is a very subjective question that you need to answer for yourself.

In both cases, be aware that your investment losses may exceed your invested capital. In most cases, using leverage to invest is not advisable. Seek expert advice for your individual situation.

Moving on to the second category, derivatives. 

First, there’s options. Typically, exposure is gained through buying call options (i.e. the right to acquire an asset at a certain price), with some market participants instead opting to build exposure by selling put options (i.e. the obligation to acquire an asset at a certain price), which is significantly more risky. We’ll focus on call options for now.

Call options are actually our preferred way of gaining leverage. They provide asymmetric risk-reward, as you participate fully in the upside of an asset while limiting your loss to the premium you pay when acquiring the option. That, of course, is also part of its downside - the time value of the option declines continually. Hence, in a sideways market your option may lose you money despite the market being flat. And eventually, your option might expire worthless if the strike price isn’t exceeded at the end of the term.

Furthermore, options aren’t as hands-off as portfolio leverage. If you want to do it right, you need to continuously rebalance (to the desired “delta”) and roll your options to make sure that you maintain your desired exposure. Also, if your option strategy does well, the rolling results in an ongoing realization of gains, which has a higher tax drag than simple instruments like ETFs. 

Lastly, also in the derivatives category, there’s futures. Futures are likely the most cost- and time-efficient way of gaining leverage. You agree on a future buying price (hence the name) for the underlying at a specified point in time (the delivery date) and only have to put down a fraction of the value as margin. For example, if 10% margin is required, you could potentially lever your portfolio by 10x. 

However, as with a margin loan, futures require diligent liquidity and collateral management to avoid margin calls: As futures are settled daily, you immediately receive any gains incurred, or pay for losses in your futures. This can also lead to an ongoing tax drag. Since the futures price already includes the expected interest rate over the tenor, you should also ensure that your collateral (i.e. the remaining 90% of your portfolio in our 10%-margin example) is well-invested to generate those implied interest costs. Futures also need to be continuously “rolled” into the next maturity at or before the delivery date - however, many brokers offer automatic rolling programmes.

Closing Remarks: To Lever, Or Not To Lever

Each of those options could be a long-term, strategic component of your portfolio. But as with every investment, any decision should be made diligently, and fit your specific needs. In regards to desired return, but even more so, in regards to risk.

Which brings us to our final question: Should you consider leveraging your portfolio, or not?

Most investors would rather make more money than less money. Markus and I are no different in this regard. But as we like to often highlight in this newsletter, you should make sure to find the right balance between risk and return.

For example, let’s say you need a 6% annual return on your diversified portfolio to achieve your long-term income requirement. 6%, in our view (although we know other advisors differ) is a return that can reasonably be achieved with a well-diversified, liquid portfolio. 

Yes, you could lever that portfolio to a higher target return, i.e. 7% or 8%. But for you to do it on your own - is it worth the risks (including path dependency), the hassle? We’d say no. If you want to lever with the goal of boosting returns, we’d advise to do that separately from your core, long-term portfolio.

Let’s take a look at another example. Let’s say your target return is 8% per year, and your portfolio is fully invested in public equities. Equities are often said to generate a long-term return of around 6-9% p.a., meaning that there is a chance that you wouldn’t hit your target return. If anything, you want a small buffer So why not lever your equity portfolio to a 10% target return?

In theory, that works. Using some very simple math (e.g. 8% expected return minus 3% funding costs [2% EURIBOR + 1% for the bank] = a 5% “carry”), you would need to lever your portfolio by ~40% to match the expected return to your 10% target return. Definitely on the riskier side, but still a buffer to the maximum leverage of 70-80% that a bank may offer you.

But that would result in the same thing as we warned about the Amumbo: It makes an already risky investment (i.e. equities with frequent drawdowns of 20-50%) substantially more risky. A drawdown of ‘just’ 30% would almost cut your initial investment in half (-42%).

To get to better results, we have to take the somewhat un-instinctive step away from equity-centric thinking (“equities have the highest expected return, so I should be 100% in equities”) towards a risk-adjusted return thinking (“combining various assets might lower my return but might disproportionally reduce my risk”). Then, leverage can come in again, to help us achieve more satisfying results: If we don’t put leverage on very risky assets, but instead a more balanced portfolio, we can actually construct a portfolio with an expected return equal to our target return, but at a (much) lower risk than if we were to do so through a 100% equity portfolio.

Which brings us back to our prior question: To lever, or not to lever?

For volatile underlyings, stock or other assets, we would say no. Only do so if you can expect a full loss of your principal, or in the case of margin loans, really limit it to an absolute amount that you can easily repay through other parts of your portfolio.

For diversified portfolios, it is worth considering. For reasonable target returns and diversified portfolios, we often see potential to build leveraged portfolios that match expected equity returns, but at a fraction of the risk. As mentioned before, we also think that call options can provide favorable, downside-protected leverage for further upside potential.

Leverage really is a very powerful tool, but it should be used with caution. If you don’t need it to achieve your target return, we find it best not to use it at all. But if you really want to, make sure to do it prudently. And don’t hesitate to reach out to us for assistance.

Liked what you read? If you enjoyed this piece, make sure to subscribe by adding your email below. I write about topics covering the world of family offices, asset allocation, and alternative investments.