When the double and triple leveraged ETFs first came under scrutiny, one commenter complained that it was unfair: the individual investor should have the same access to leverage as his professional peers, and the SEC had no business asking questions. Attitudes toward leverage vary, and the types of leverage available to different classes of investors vary. Finally the question comes up, how much leverage (if any) is useful, and what types of leverage are safest or most affordable?
Please bear in mind that I am an independent investor, not a market professional or some kind of guru, and when voicing opinions I am not giving advice, only talking shop.
The High Rollers - Lehman Brothers (OTC:LEHMQ) was levered at 30 to 1, or maybe more, if the Repo 105 transactions are factored in. LTCM was levered at 20 to 1. In cases of this type, a high volume of transactions with a slim margin is levered up to gain high returns. It breaks down when the fat-tail event occurs. That type of behavior occurs over and over when regulatory laxity permits it to go on, the more so when moral hazard rears its head, the lovely offspring of TBTF.
Margin - Warren Buffett's opinion, according to Charlie Munger:
Warren and I are chicken about buying stocks on margin. There's always a slight chance of catastrophe when you own securities pledged to others. The ideal is to borrow in a way no temporary thing can disturb you.
My father, a successful investor, experimented with margin as a young man, concluding you couldn't earn money fast enough to pay the interest, and advised me accordingly.
Parsing these statements, Buffett doesn't mind using borrowed money, but will not expose himself to margin calls. Dad arguably might have used margin if the interest rates were low in proportion to his expected return. I don't normally use margin, the exception being in March and April last year, when historic lows suggested returns would be well in excess of interest costs. I got away with it.
The problem is margin calls: They guarantee that the investor/speculator will sell at the bottom, and make decisions under considerable stress and pressure. Your friendly broker may very well change the maintenance requirements or margin eligibility of stocks you own at very inconvenient times, as I learned to my consternation last year. Margin is not good.
Other Borrowing – Objectively, there should not be a problem using borrowed money to invest in the stock market, provided the expected return from stocks can realistically be expected to exceed the cost of interest. As long as the stock is not subject to margin calls, the investor can hold through any dips and avoid selling at the bottom.
Unfortunately a house is frequently the main asset available to secure credit. I personally dislike the idea and would not use it in practice.
Double and Triple ETFs – These concoctions are fundamentally dishonest, because they don't work over the long haul. For a day, they work. Left unattended for any substantial period of time, they decimate wealth. The money lost goes somewhere: I would suggest that it winds up in the hands of those who organize them, sell them, and most importantly, trade with them.
Options – The use of deep in the money LEAPS as a substitute for stock ownership achieves leverage at an affordable price, but is subject to cautions and complexities in practice. My personal experience, and such analysis as is possible with limited tools and skills on a huge range of possible outcomes, leads me to conclude that the strategy is effective, provided 1) it is supported by sufficient cash to permit proper adjustments under an array of negative circumstances, 2) ways are found to harvest enough time premium to fund some of the time values of the LEAPS purchased and 3) expected returns are well above the cost of maintaining the positions.
Expected Returns – Using my preferred method, I have a two year target of 1,400 for the S&P 500. From a recent reading of 1,047 on the index, an annualized return of 15.6% is implied. Because this is substantially greater than the cost of maintaining leveraged positions by the use of options, I am willing to accept the increased volatility, risk and trading costs associated with the strategy.
Briefly, it is possible to compute the time premium on an in the money option and construe it as interest on a notional loan of the strike amount. With Exxon (XOM) at 57.95, buying a Jan 2012 50 call for 12.25, the time value is 4.30. Dividing by 50 (the strike), the interest is 8.6%, for 563 days. Annualizing that, the time cost when construed as interest is 5.6%. So where the cost of the “borrowed” funds is less than the expected return, the strategy seems logical. Deeper in the money reduces time premiums.
By selling short-term out of the money calls against the position it is possible to offset the time cost. Other strategies can also help reduce time cost. Probably it makes sense to think of the LEAPS strategy as having an implied cost of capital of around 5%.
As of for example 4/23/10, with the S&P at 1,220, the yield implied by a two year target of 1,400 would have been 7%, at which point the cost and risk of a leveraged position would have been less appealing.
Asymmetrical Leverage – Simply levering a portfolio up 3X and then watching it gyrate with the market doesn't seem useful and might be dangerous; who wants to get off the roller coaster at the bottom of its run when it is going 90 mph? It is more logical if high leverage is applied at low points and then reduced severely at high points.
It is even better if the means used to achieve leverage works along those lines. It is possible to make some progress using options, with results that vary according to the accuracy of the market predictions that underlie the effort. Simple models applied to quarterly S&P data over the past 30 years suggest a properly constructed portfolio leveraged with options would have seriously out-performed the index, and would be unlikely to blow up at the bottom. A portfolio attempting similar leverage with margin would self-destruct repetitiously.
How Much Leverage – It depends on what kind. A little bit of margin or 3X ETF or Repo 105 goes a long way, not necessarily in the right direction. Somewhat more leverage applied by other means seems to produce tolerable results.
My experience using options for leverage has been relatively pleasant, but hardly uneventful. Logically there is little reason to use leverage if the investor thinks the market is anywhere near fairly valued; and progressively better reason to apply more as the market appears undervalued, particularly if margin calls can be kept out of the mix.
Experimental Portfolio - My discretionary portfolio at this point has enough leverage applied by means of LEAPS that it is something of a test case. The acid test is, if and when the S&P gets back in the area of its April 23 high, how will my profit/loss for the round-trip compare with the index?
I applied a generous amount of hedging at the high point, and reduced leverage to less than 1X at the time. As the market, and the portfolio with it, has declined, I have systematically removed the hedges and increased the amount of leverage, to where as of today functional leverage appears to be in the area of 2.5X. The portfolio is supposed to outperform the S&P by 15% peak to peak. We'll see what happens. Never a dull moment.
Right now I am working on rolling the Jan. 2011 LEAPS expirations out to 2012, at least for cases where I think the position has good long-term potential. The point is that by keeping expirations well into the future it is a lot easier to avoid pressure around expiration dates and the options behave more predictably as the market gyrates. This can be tedious work but with the volatility in the market it may be possible to leg from one position to the other without leaving too much money on the table.
Disclosure: Author long XOM, portfolio strategy uses options as described