Three Types of Leverage for This Volatile Market

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Includes: ACAS, EEV, FAS, SEA, SSO
by: Alan Young

When the market goes up, we often wish we could get returns on a higher amount of investment than we have at our disposal. In fact, we can. Getting returns (or losses, of course) on more money than your apparent stake is called leverage.

I know of at least three ways individual investors can use it. (There is a fourth, but it's a bit more complicated).

1. Leveraged ETFs

The newest and most popular form of leverage is in specialized ETFs. If you like SPY, expecting it to go up 3%, why not buy SSO, which should go up 6%? If you like financials (NYSEARCA:XLF), you should love FAS, which triples your returns.

These products have obvious advantages. They track well-known indexes, so they are completely transparent as to nominal value, and market value can be monitored in real time like any other stock.

The problem is that the value is re-calibrated daily. If you are following a trend, this is great, because your gains are compounded. But if the index is volatile, the counter-trend moves are magnified more than the primary trend moves when the price is re-calibrated. Over time, that can reverse gains to losses.

You can be well aware of the fundamentals of your trade, so you can succeed at predicting a long-term trend. And you can be a good technical analyst, so you can succeed at finding a good entry point. But I don't know any set of techniques that can give you any assurance that your long-term trend will be free of volatility. That makes it very hard to avoid the calibration risk of leveraged ETFs, except by using them only for short-term trades. So this is my least-favorite leverage tool.

2. Leveraged Equity

Buying equity in a company that uses leverage to boost its returns increases your exposure to those returns. REITs are probably the best-known example of this. Typically, a fund pays for only a small percentage of the real estate it buys, carrying the rest as mortgages. The cash flow provided by leasing the real estate services the mortgage, and in good times provides a substantial surplus for the investors.

Shipping is a similar model, with ships instead of buildings. A small ship-owning company borrows enough to build some ships, leases the ships to traders, and services the loans with, ideally, plenty left over for the investors.

A less obvious type of leveraged equity is the Business Development Corporation (BDC). BDCs borrow cheaply, and invest in small private businesses, seeking a high return. An example isACAS , currently trading at a little over $3. Their portfolio of investments is currently valued at over $7/share; if these investments successfully reach maturity, they are expected to be worth almost double that. So your purchase of shares in ACAS give you at least 2x, maybe 4x leverage on the portfolio.

The advantage of this type of leverage is that all of these types of equity produce cash flow. Cash flow has been the key to funding sea voyages and real estate ever since Medieval times, and typical rates of return are still in the same range it was then: 10-20%.

The disadvantage, however, is obvious to anyone who hasn't been living in a cave for the last year. It only works as long as the cash flow is unimpaired. When tenants can't pay their rent, shippers have no cargo to move, or small businesses go bankrupt, the value of your assets can crash quickly.

Furthermore, investors in these companies usually have a hard time assessing the risk, because it depends not on what is happening on any public market, but on counterparties who may not be visible. ACAS stock went from $40 to its current $3, not because it couldn't make payments on its loans, but because the companies it made loans to couldn't make theirs.

Still, the upside can be great, and general economic and credit conditions do provide enough clues to make intelligent investments on long-term trends. I have made some excellent returns in BDCs and REITs this year.

3. Margin

It's 1929, and the stock market is making everyone rich. You only have $50 to invest? No problem! After a $5 commission, your $45 buys you $450 in stock, using the leverage of margin. In just a week—or two weeks, tops—you'll double your money!

Well, we all know how that story ends, and 1000% margin is no longer allowed. But 50-100% often is.

If I have 100% of my equity allocation already deployed, and feel that the opportunity to buy stock in XYZ is too good to pass up--that is, that it's worth the risk of leveraged exposure-- I can just buy on margin, with the rest of my portfolio standing as collateral. My brokerage provides the loan to buy the securities, for a reasonable interest rate (currently about 8%)

Of course, just as gains are magnified by leverage, so are losses, and I'd hate to be in a market-wide meltdown of, say -20% starting from a position leveraged by margin. It's still possible to lose just about everything, if you risk too much. But to the extent that I am able to compute it, a modest use of margin is the most efficient way to gain both leverage and liquidity. You can buy any kind of asset with it, and calibrate the amount of risk you want with precision. If I leverage to 110% to buy XYZ, and XYZ goes to zero, I lose 10% of my portfolio as collateral. That's no worse than any other 10% loss.

My favorite use of margin is to invest in hedge positions: for example, if I have a basket of emerging-market stocks I want to hold but fear a temporary downturn in EMs, I can buy an inverse fund like EEV to neutralize my exposure to that sector. And if I'm fully invested, I can use margin to buy the hedge, at essentially no risk.

Over time, 8% interest can eat up a lot of gains, so be sure to use the opportunity judiciously.

Disclosure: no positions in securities mentioned.