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Summary

1. Theoretically, when does it make sense to use leverage?

2. Historically, has it made sense to use leverage?

3. For the same level of risk, is it better to be “100% in Stocks” OR “Add leverage to a Balanced Portfolio”?

4. How much can you borrow without worrying about a margin call?

5. Appendix: Risk and return metrics for “100% Stock” and “60% Stock / 40% Bond” Portfolios

The InvestQuest View

• We do see value in borrowing to invest, particularly if one is invested in a diversified multi-asset portfolio. This is especially so in recent years, where borrowing costs are at record low levels. Based on historical data, it appears that investors can borrow up to 27%* of their gross portfolio value and be relatively assured that a margin call is unlikely, with the caveat that the margin rates are not reduced significantly during market downturns.

• That said, the decision to take leverage requires thoughtful consideration. Taking leverage can become a habit, and it can be difficult to glean yourself off even when the situation becomes unfavorable (e.g. when valuations are toppish, when interest rates start climbing). We’ve certainly heard several stories of investors getting margin calls during a market downturn and being forced to sell their stocks/bonds at distressed prices.

* Note: Regarding the 27% mentioned above, our analysis assumes that the invested portfolio is diversified and has a lending value of 65%. Brokers have the discretion to reduce lending values on securities, which happens mainly during crisis periods. The combination of a decline in security prices and reduction in lending values are often what results in unexpected margin calls, so we would advise leveraged to always have some emergency cash available in the chance that cash top ups are required.

• For portfolios holding concentrated positions or illiquid securities, it would be prudent to use lower amounts of leverage, as margin rates on specific securities may be reduced at the broker’s discretion. Furthermore, there will be higher security-specific risks.

• Lastly, our analysis was based on historical data (past 20 years), which may not similar to future trends.

Disclaimer: We present this analysis as a record of our journey as investors! Please do not rely on the article for your financial and investing decisions. As always, do your own due diligence!

1) Theoretically, when does it make sense to use leverage?

In our view, it makes sense to borrow to invest when:

1. Expected returns from the investment exceeds the cost of borrowing

2. The probability of a margin call is negligible

3. You are investing in an asset denominated in a foreign currency and borrowing helps to hedge FX risk.

2) Historically, has it made sense to use leverage?

We want to see if taking leverage has made sense for the following portfolios:

• Stock Portfolio – consists of 100% stocks

• Balanced Portfolio – consists of 60% stocks & 40% bonds

Effect of Leverage on Returns (2001 to 2020)

Let’s see whether taking leverage had a positive effect on returns over the last 20 years. We ignore the added risk for now.

Short answer:

• “Stock Portfolio”: Taking leverage had No Significant EFFECT

• “Balanced Portfolio”: Taking leverage had a POSITIVE EFFECT

One reason for this is because at the start of 2001 and between 2005-07, the borrowing cost was much higher (see chart of 1-Month USD Libor below), which meant that investment returns had to be much higher in order to be accretive to returns.

In the table below, we show the annualized returns for 100% Stock Portfolios vs Balanced Portfolios (60% Stock & 40% Bonds), at varying leverage levels. To clarify, “20% Debt” would mean that for a portfolio size of $100, $20 is in borrowings and $80 is the investor’s capital.

Source: Bloomberg, IQ computations. MSCI All Country World Index (USD Net) was used as a proxy for the stock allocation, while the Bloomberg Barclays Global Aggregate Index was used as a proxy for the bond allocation. The portfolio’s leverage ratio is assumed to be static across the time period, and the cost of borrowing is assumed to be at 1.5% above the 1-month USD Libor.

Effect of Leverage on Returns (2011 to 2020)

Let’s see whether taking leverage had a positive effect on returns over the last 10 years. We ignore added risk for now.

Short answer:

• “Stock Portfolio”: Taking leverage had a POSITIVE EFFECT

• “Balanced Portfolio”: Taking leverage had a POSITIVE EFFECT

Our Explanation: Since the Global Financial Crisis in 2008, borrowing costs have come down significantly (see above chart of 1-Month USD Libor). Because of this, leverage has had a positive impact on portfolio returns.

Source: Bloomberg, IQ computations. MSCI All Country World Index (USD Net) was used as a proxy for the stock allocation, while the Bloomberg Barclays Global Aggregate Index was used as a proxy for the bond allocation. The portfolio’s leverage ratio is assumed to be static across the time period, and the cost of borrowing is assumed to be at 1.5% above the 1-month USD Libor.

OUR PERSONAL TAKE

We note that the long-term use of leverage DOES NOT always result in higher returns (despite the higher risk). As we noted above, this seems to be the case especially for “100% Stock Portfolios”.

Meanwhile, leverage has a higher chance of enhancing portfolio returns when the portfolio is well-diversified across asset classes, like in the “Balanced Portfolio”.

For our own portfolio, we do believe in using modest amounts of borrowings to invest. Borrowing costs are currently low, which increases the probability that the use of leverage will be accretive to portfolio returns, especially if the portfolio is diversified and multi-asset.

3) For the same level of risk, is it better to be “100% in Stocks” OR “Add leverage to a Balanced Portfolio”?

What’s the definition of risk? In finance, that usually refers to how much volatility there is in the portfolio.

There are two ways to add risk to a portfolio:

• Increasing stock allocation

• Increasing leverage

When investors have an aggressive risk profile, the common thinking is to invest in a portfolio with a larger allocation to stocks. It’s less common to consider the possibility of using leverage on a balanced portfolio, which is another way to add risk.

So let’s compare the following:

• 100% Stock Portfolio WITHOUT leverage (“Stock Portfolio”)

• 60% Stock/40% Bond Portfolio WITH leverage (“Balanced Portfolio + Leverage”)

Would the benefits of diversification outweigh the cost of borrowing? In the following sections, we compare the two based on:

1. risk-adjusted returns

2. worst sell-off and subsequent recovery time

Comparing Risk-Adjusted Returns

We wanted to see to compare the risk-adjusted returns of a “Stock Portfolio” with that of a “Balanced Portfolio + Leverage”.

In the table below, rational investors should desire portfolios with

• the same or higher returns…

• but with lower volatility

For the period between 2001 to 2020, the “Balanced Portfolio + 20-35% Leverage” had a clearly better risk-adjusted return than the “Stock Portfolio”.

Source: Bloomberg, IQ computations. MSCI All Country World Index (USD Net) was used as a proxy for the stock allocation, while the Bloomberg Barclays Global Aggregate Index was used as a proxy for the bond allocation. The portfolio’s leverage ratio is assumed to be static across the time period, and the cost of borrowing is assumed to be at 1.5% above the 1-month USD Libor. To clarify, “20% Debt” would mean that for a portfolio size of $100, $20 is in borrowings and $80 is the investor’s capital.

Comparing Worst Drawdowns & Subsequent Recovery Time

We wanted to see to compare the worst sell-offs (% change) and the recovery time (years) of a “Stock Portfolio” with that of a “Balanced Portfolio + Leverage”.

Rational investors should desire portfolios with:

1. smaller portfolio declines during the worst sell-offs

2. a quicker recovery after a sell-off

For the period between 2001 to 2020, the “Balanced Portfolio + 35% leverage” faced a similar worst peak-to-trough portfolio decline as the “Stock Portfolio” (see table below). However, it was able to recover fully within 2.1 years, compared to 4.2 years for the latter.

Source: Bloomberg, IQ computations. MSCI All Country World Index (USD Net) was used as a proxy for the stock allocation, while the Bloomberg Barclays Global Aggregate Index was used as a proxy for the bond allocation. The portfolio’s leverage ratio is assumed to be static across the time period, and the cost of borrowing is assumed to be at 1.5% above the 1-month USD Libor. The “Peak-to-Trough (Years)” indicates the duration of the sell off. The “Recovery Time (Years)” indicates the time the portfolio took to fully recover the peak-to-trough losses (from the date of the market trough).

More details of the above analysis may be found in the Appendix.

In summary, it appears that taking a modest amount of leverage on a “Balanced Portfolio” offered a better risk-reward than a “100% Stock Portfolio”.

Our thoughts on this section have been influenced by Bridgewater, the world’s largest Hedge Fund. Hence, we find it apt to quote from one of their whitepapers:

“…If investors can get used to looking at leverage in a less prejudicial, black-and-white way… I believe that they will understand that a moderately leveraged, highly diversified portfolio is considerably less risky than an unleveraged, non-diversified one.”_

4) How much can you borrow without worrying about a margin call?

The answer is shown in the orange highlighted cells in the table below, and it depends on the asset allocation of your portfolio. We will explain how these figures have been reached.

Source: Bloomberg and IQ computations.

In the table above, we highlight the worst Peak-to-Trough portfolio declines, across varying asset allocations, in the last 20 years. Do note that the indicated “Peak-to-Trough” declines assume that the portfolios are not leveraged. We are using this information to reverse engineer the maximum leverage one could have taken on hindsight and not be triggered with a margin call.

Let us run through an example based on the 100% Stock portfolio that had a -58.38% Peak-to-Trough portfolio decline.

1. If the investor had invested $100, and the portfolio subsequently experienced a -58.38% decline, the investor’s portfolio would then have a value of $41.62.

2. If we assume that the diversified portfolio had a lending value of 65%, it would imply that the portfolio had a collateral value of $27.05 ($41.62 multiplied by 65%) during the market trough.

3. The $27.05 collateral value would correspond with the maximum borrowings that the investor could have taken (on hindsight), while not triggering a margin call.

More details of the above analysis may be found in the Appendix.

Based on the above results, it would imply that investors can borrow up to 27% of their gross portfolio value and be relatively assured that a margin call is unlikely. This would be especially so if the portfolio is diversified and multi-asset.

Do note that the above analysis assumes that the invested portfolio is diversified and has a lending value of 65%. Brokers have the discretion to reduce lending values on securities, which happens mainly during crisis periods. The combination of a decline in security prices and reduction in lending values are often what results in unexpected margin calls, so we would advise leveraged to always have some emergency cash available in the chance that cash top ups are required.

The InvestQuest View

• We do see value in borrowing to invest, particularly if one is invested in a diversified multi-asset portfolio. This is especially so in recent years, where borrowing costs are at record low levels. Based on historical data, it appears that investors can borrow up to 27%* of their gross portfolio value and be relatively assured that a margin call is unlikely, with the caveat that the margin rates are not reduced significantly during market downturns.

• That said, the decision to take leverage requires thoughtful consideration. Taking leverage can become a habit, and it can be difficult to glean yourself off even when the situation becomes unfavorable (e.g. when valuations are toppish, when interest rates start climbing). We’ve certainly heard several stories of investors getting margin calls during a market downturn and being forced to sell their stocks/bonds at distressed prices.

* Note: Regarding the 27%, our analysis assumes that the invested portfolio is diversified and has a lending value of 65%. Brokers have the discretion to reduce lending values on securities, which happens mainly during crisis periods. The combination of a decline in security prices and reduction in lending values are often what results in unexpected margin calls, so we would advise leveraged to always have some emergency cash available in the chance that cash top ups are required.

• For portfolios holding concentrated positions or illiquid securities, it would be prudent to use lower amounts of leverage, as margin rates on specific securities may be reduced at the broker’s discretion. Furthermore, there will be higher security-specific risks.

• Lastly, our analysis was based on historical data (past 20 years), which may not similar to future trends.

Disclaimer: We present this analysis as a record of our journey as investors! Please do not rely on the article for your financial and investing decisions. As always, do your own due diligence!

Appendix: Risk and return metrics for “100% Stock” and “60% Stock / 40% Bond” Portfolios

Source: Bloomberg and IQ computations.