How To Use Leverage To Boost Your Returns -

How To Use Leverage To Boost Your Returns

Dec 26, 2024Jeremy ParkinsonFinance0

Image Source: PexelsLeverage can be a powerful tool in increasing your returns, but it must be used very carefully. This brief guide will attempt to cover margin, hedging, and related issues.

Financing Your Investments
In theory, if your expected returns on an investment are higher than whatever interest you might pay, it makes sense to increase your investments with borrowed money. But there is one important caveat. If your investment has variable returns, that fact can negate the increase.For example, let’s say your expected return is 10% and you can borrow money at 7%. (These rates match the long-term expected return of the stock market and typical margin borrowing costs.) If you lose lots of money in the first year and then bounce back in the second and third so that your 3-year compound average growth rate (CAGR) is 10%, you still might end up worse off than if you hadn’t borrowed any money at all. This is due to what’s called sequence-of-returns risk. For example, let’s say you have $10,000 to invest and you borrow $5,000 at 7%/year interest. Your portfolio goes down 40% the first year, so you have $15,000 × 60% – 7% × $5,000 = $8,650. Your portfolio goes up 8% the second year, so you have $8,650 × 108% – 7% × $5,000 = $8,992. The third year you bounce back with your portfolio, scoring a 105.4% return for a CAGR of 10%. Your portfolio is now $8,992 × 205.4% – 7% × $5,000 = $18,120. At this point you pay back the $5,000 in debt for a total three-year return of $3,120. If you had invested your $10,000 without using any debt, though, your return would be 1.1³ × $10,000 – $10,000 = $3,310, which is significantly higher.So financing your investments with debt only makes sense if at least one of the following is true: a) the difference between the expected return and the interest charged is quite large; b) the expected return is relatively steady; c) you minimize your short-term losses by using an effective hedge.The only two relatively inexpensive ways to finance your investments that I’ve been able to find are cash-back mortgages and margin. The interest on both can be deducted from your taxes. Other loans tend to be far more expensive. Mortgage financing is relatively straightforward and cheap if you get a fixed-interest mortgage. I did this twice and due to compounding effects I made a huge amount of money hereby. Margin, however, is considerably more complicated.

Margin in a Nutshell
If you obtain margin on your portfolio, you borrow money from your broker using the securities you own as collateral. The amount your broker will allow you to borrow will depend on the value of your securities. If you borrow a significant amount and the value of your securities drops, you may face a margin call, asking you to deposit more cash in your account to cover the margin. If you fail to do so, the broker will liquidate your positions in order to settle the debt. This could wipe you out completely. Believe me: this happened to one of my best friends.There are two basic types of margin: Regulation T margin and portfolio margin. Portfolio margin is significantly more difficult to obtain.

The Basics of Margin
Every position in a margin account has a margin requirement. At most brokers, the margin requirement is 100% for small, illiquid, foreign, and/or OTC stocks, as well as for uncovered options positions. At Fidelity, the margin requirement drops to 30% for very liquid stocks that are not concentrated positions or that are in sectors that comprise less than 20% of your portfolio. Margin requirements will vary between 30% and 60% for positions that are in-between those two extremes. For stocks whose price is between $3 and $10, the margin requirement will often be $3 per share.Margin requirements are not intuitive, so let me explain their significance.Below is a snapshot of the positions in my margin account at Fidelity in early October, along with their margin requirements.The totals of the numbers in the “Position Value” column are the market value of my holdings (around $643,409). The “Dollar requirements” column consists of a) if the percentage requirement is a percentage, the product of that percentage and the position value; or b) if the percentage requirement is a dollar amount, the product of that dollar amount and the number of shares held. The total dollar requirements amount to about $265,404. At this point I had $223,185 in debt (this is not shown on the above chart). So my margin equity was the market value minus the debt, or $420,224. And my surplus was the margin equity minus the dollar requirements, or $154,820.The surplus is the number you must watch if you’re using margin. As you can see, if the requirement is high (100% or $3 on a $3 stock), your surplus will be low, while if the requirement is low, your surplus will be high.How much margin was I using at this point? Well, the amount of debt divided by the market value was about 35%, so I was using 1.35X margin. This number has a direct impact on your returns. For every dollar your investments gain you’ll be richer by $1.35; for every dollar your investments lose, you’ll be poorer by $1.35.I have only faced a margin call once, when I was almost finished depleting a margin account. The key to avoiding calls is to always keep an eye on the surplus. Because margin requirements can go up at any time, I calculate what the surplus might be if all my margin requirements went up by 5% and my securities all went down in value by 20%, and keep that possible future surplus above zero. If the VIX (the CBOE Volatility Index) is high, I increase the 20% in the above sentence to 25% or 30%.

Reg T Margin
It’s not really essential to understand the rules of Regulation T Margin, which are very complicated. Suffice it to note three things.

Reg T will effectively cap your margin use at 2X, even if your margin requirements are all 30%.

If your securities appreciate, your Reg T surplus can go up, but if your securities depreciate, it won’t go down unless you buy or sell something in your portfolio. In other words, a market crash will not cause a Reg T call.

Your broker will very likely stop you from doing anything that would result in a Reg T call.

Portfolio Margin
Portfolio margin allows one to evade Reg T requirements; typically the margin requirements can be as low as 15% to 18%. The entire portfolio behaves as if it has one overall requirement. This allows you to use a positively unhealthy amount of leverage (up to 6X in some cases), and can result in very risky behavior. But it also makes your life considerably easier because you’re much, much less likely to be in danger of a margin call as long as you keep your leverage below 2X or 3X.Different brokers have very different requirements for portfolio margin. Fidelity rarely grants it; Interactive Brokers grants it frequently but if you’re trading heavily in microcaps or foreign stocks the margin requirements are onerous. StoneX, the broker for my hedge fund (Fieldsong Investments), has allowed me to use portfolio margin, and it’s considerably easier to use than Reg T margin.

Leverage and Hedging
Without a hedge, the use of leverage can be disastrous. Because leverage multiplies one’s losses just as much as one’s gains (or more if you count the interest you pay), the risks one faces when using leverage are enormous. That’s why it’s advantageous to hedge your portfolio when using leverage.I’ve been using put options on stocks likely to collapse to hedge my long equity positions. I’ve written about this strategy here. This kind of hedge is useless at counteracting small losses, and loses a huge amount of money during periods of market gains. But during significant corrections and bear markets, it tends to increase stratospherically. Below is a chart illustrating the relationship between a put hedge and the returns of a portfolio of the underlying stocks. This is based on the actual returns of my own investments in puts and assumes a portfolio of a dozen or more underlying stocks and a holding period of about 100 days.You can see that if the portfolio has no gain or loss, the hedge loses between 5% and 10%. If the portfolio gains 20%, the hedge will lose about 40%. If, on the other hand, the portfolio goes down 10%, the hedge will go up between 15% and 20%, and if the portfolio goes down 20%, the hedge will go up about 50%. By the time the portfolio goes down 30%, the hedge will have gone up over 100%. Here’s a rough formula: y = –8.3x³ + 3x² – 2x + 0.07, where y is the put hedge return and x is the portfolio return. (Remember that this is assuming a 100-day period.) This formula was derived from the trendline in the above chart.You can easily see, then, that a hedge like this will make it much easier, safer, and more profitable to use margin. There are other hedging options too: you could sell short a portfolio of stocks, or you could invest in an inverse ETF.Here’s a graphic illustration of what can happen when you combine leverage with a hedge:You’ll see that in this example the put hedge alone loses money: a lot of money. Between 1999 and today it loses more than 99% of its value. But with regular rebalancing, it shores up the returns during downturns. Here are the numbers:(CVAR is the conditional value at risk at 10%, which means the average of all monthly returns below the 10th percentile of monthly returns. In my opinion, CVAR at 2%, 5%, 10%, and 15% are the best measures of risk available.)These are, of course, hypothetical portfolios, and your actual portfolio may differ a great deal from them. I’ve done a huge amount of playing with various scenarios, and I’ve settled on a relatively conservative strategy for my hedge fund: use around 1.3X to 1.4X leverage and hedge that with around 8% to 10% puts. Feel free to try your own backtests, though, to come up with your own levels. Here are some rough guidelines:

Don’t be too optimistic. Never backtest a best-case scenario. Even a realistic scenario based on actual out-of-sample returns is probably not bad enough for a good backtest. You’re better off preparing for a worst-case scenario than aiming for realism.

Don’t look only at CAGR. Also look at median quarterly returns and CVARs.

Backtesting for a high Sharpe ratio will almost never favor the use of leverage, no matter how well you hedge. The same is true for CVARs. That’s why it’s important to balance measures like these with actual returns, whether they’re compounded or median.

While I’ve always advocated using alpha as a portfolio return measure, it’s useless when a hedge is involved. A few years ago I came up with a mathematical proof that when the market as a whole is showing positive returns, alpha and beta are inversely correlated. A hedge, whether it’s put-based or short-based, is going to radically decrease your beta, and therefore increase your alpha. If you’re looking for a very high alpha in your backtests, you’ll be favoring a much higher use of your hedge than is healthy for a portfolio.

Think of an unlevered unhedged portfolio as a base case. In no event do you want your CVARs or returns to be lower than that.

While it’s not very hard to adjust a short-based hedge depending on market conditions, it’s difficult and expensive to do so with a puts-based hedge. When backtesting, take into account that increasing or decreasing a hedge is a slow process. If you’re aiming for, say, a 10% hedge and the market takes a huge downturn, your hedge will balloon and it might take you a while to get back down to 10%; similarly, a huge upswing can cut your hedge percentage in half in a few days, and it’ll take some time to build it back to 10%. Options have a built-in time decay: they lose some of their value every day. This means that buying and selling puts has an opportunity cost that holding them doesn’t incur. Not only that, but their spread costs tend to be huge. That’s why it’s best to buy and sell puts slowly to avoid any unnecessary transactions.

Unhedged Leverage: An Example
In January 2022 I established a private foundation for charitable giving. I decided at the time to maximize my use of leverage by avoiding non-marginable stocks, and I did not use a hedge. To buy and sell stocks I use ranking systems I’ve designed on Portfolio123 (I also use those to determine which stocks to buy puts on). The returns have been very good: a time-weighted annualized return of 37%.Significantly, however, this is lower than the returns I obtained managing very similar portfolios for my wife and my kids over the last three years, without using any leverage at all.Part of this is due to the fact that in the Foundation account I only invest in marginable stocks, which excludes some Canadian and European stocks and all US OTC stocks, as well as a number of microcaps. But in addition, leverage is expensive (margin interest is not cheap on a highly levered portfolio), and the increased volatility, as I showed above, can harm overall returns. So at this point I’m planning to add a hedge to my foundation account. We’ll see how that goes . . .More By This Author:Drowning In Data Soup: Why Factor Investing Cannot Be Scientific How To Manage Your Portfolio To Maximize Your Returns How To Make Money Trading European Stocks