Why Moderate Leverage?

My first experience with investing was when I started my first job. It was a decent paycheque but not a huge amount, so I was only able to save and invest small amounts. Having graduated with a degree in Actuarial Science I had a strong understanding of numbers and risk, and quickly realize that the returns I was getting from my mutual funds were not going to be enough to get me on track for a decent retirement. That was me discovering the number 1 risk that we all face when planning for retirement – Longevity Risk, the risk that we don’t have enough to live the retirement we picture. In a paper published by the Center for Retirement Research of Boston College (How Well do Retirees Asses the Risks they face in Retirement?) they state the number 1 retirement risk is longevity risk – “the risk of living longer than expected and exhausting one’s resources”. Many other think tanks have come to the same conclusion.

Then I discovered leveraged ETFs. These were the 2 times leveraged ETFs, designed to provide twice the daily return of an index that they tracked. Of course this goes both ways, meaning you can lose twice as much as the index in a given day which leads to extreme volatility and means you have to be checking in on your investments every day. Most of us don’t want to do that.

With moderate leverage, anywhere between 1.1 and 1.5 times, you can still get a boosted return but without the extreme volatility and the constant trading in your portfolio. And if that moderate leverage is provided in an ETF with a rules-based trading algorithm that reduces volatility and minimizes losses, there is a good chance you are going to come out ahead long-term.

Leverage through an ETF is better than leverage from a bank

The best way to access moderate leverage is through an ETF. Leveraging through a bank or other financial institution will cost you. Here’s an example. If you have $5000 to invest in the S&P 500 over 3 years, doing it with a 1.3 times levered ETF will net you over 6% more than if you were to borrow 30% of your investment and invest $6500. That’s because you have to pay regular interest on your loan and eventually pay back the borrowed amount to the bank. With a levered ETF there are no borrowing costs. Here is what a $5000 investment looks like after 3 years, and the loan is repaid to the bank.   

*based on 3years invested in an S&P 500 Index tracking ETF up to June 30th 2023, assuming the interest rate on the borrowed funds is 6%

Treat your investments like a business

Ultimately, we are all trying to grow our investments. Similarly, if you are running a business you want it to grow, and the best way to do that is to inject capital to get some leverage and put your money to work. So if you think about your investments as a business, and really our investments are like a side-hustle that we use to help us retire earlier, then you want to add some capital i.e. leverage. Sure that adds some risk, but the extra return you get is a good trade-off, yielding the same Sharpe ratio (a ratio used to determine the risk/return trade-off of a fund, higher is better).

If you have two investments with the same Sharpe ratio, you should take the one with the better return. The point is that business owners almost always use leverage to grow, and they accept the risk that comes with that to avoid the risk of going out of business. Investors should do the same, accept slightly higher risk on investment returns in order to reduce the risk of not having enough to fund their retirement.

Leverage will help you beat expected returns

Expected returns in the stock market are dropping according to Martin Scmaltz, Professor of Finance and Economics at the University of Oxford and William Zane, Professor of Economics and Math at UCLA. They wrote a paper titled “Index Funds, Asset Prices, and the Welfare of Investors” showing that as index funds get bigger, it drives up stock prices and reduces expected returns. They conclude that “While it is true that the availability of index funds allows small investors to enjoy market returns, at equilibrium, these market returns are lower than those that were enjoyed by investors before index funds became available”. The best way to get back that higher expected return is to add a little bit of leverage.

Capitalize on the market ups

Markets are up more than they are down. Since May 2000, the S&P 500 had a positive daily return 54% of the time, over the past 10 years 54%, over the past 5 years 54%. It’s not a trend. Focusing on downside protection is important, but if it’s the primary goal of a portfolio or the only goal, then the portfolio is going to miss a significant part of the returns, and probably won’t make any money, leaving you short of retirement goals.

One of the key tenets of index investing is buy-and-hold. Trying to time the market has proven to be almost impossible. So if you’re in the market for the long term, not selling through ups and downs, why not boost the returns you’re getting? If you have a 5 year or longer investment window, and history repeats itself, you will come out ahead.