Leveraging, or using borrowed funds to increase your invested capital, has the potential to significantly increase returns. But there are risks, as well. This type of strategy works and when it might be suitable for the sophisticated investor.
How does leveraging work?
Suppose you have a portfolio of equities and fixed-income securities worth US$1 million that earns a rate of return of 4.5% annually, or about $45,000. Using these assets as collateral, you might borrow, say, $600,000 to invest in additional bonds and equities. If you continue to make 4.5%, your overall portfolio will then earn $1.6 million X 4.5% = $72,000 annually.
Obviously, there is an increased cost, because of the interest payments on the loan. But depending on the size and term of the loan, the interest you pay may be relatively low. In this example, if it’s 3.0%, then your annual interest costs on the $600,000 loan would be about $18,000. You’d still make $54,000 in a year, for an annual return of 5.4% on the $1-million you have invested.
Does leveraging have any other uses?
You can also use leveraging to increase the diversification of your portfolio without selling your current holdings. For example, if you have a portfolio of primarily fixed income-based investments, you can leverage it to invest in equities. Similarly, if you wish to expose your portfolio to the potential returns in foreign markets, you can do so by investing the borrowed amount in foreign securities.
Leveraging can also help you adjust your asset mix as your investment objectives change over time. For example, if you are approaching retirement and want to preserve more of your capital, you may consider leveraging your equity portfolio to add more fixed-income securities rather than selling your equities and possibly incurring tax consequences.
What risks are involved?
Along with higher potential gains, leveraging carries the risk of magnifying potential losses. If the value of your portfolio drops, not only do you lose the rate of return, but you may be issued with a margin call. This occurs when the value of your securities falls below the minimum collateral required by the lender. You’ll have to make up the difference by supplying additional cash or securities to your account or sell some of your securities, possibly at a loss.
For what kind of investor is leveraging most suitable?
Leveraging typically appeals to sophisticated investors who are concerned with preserving their wealth while also seeking potentially higher returns. But they need to understand the way leveraging works and must be aware that the increased potential rewards are accompanied by greater potential risks.
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