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When Investment Theory Fails: Leverage

The concept appeals, but the reality does not.

Reversing Field I had intended this column to be something else.

Last week, I summarized William Sharpe's long-standing claim that aggressive investors should leverage the market portfolio, rather than buy ever-riskier stocks. For one, argued Sharpe, the leveraged-market portfolio is better diversified. For another, discovered future researchers, those riskier stocks aren't much good. They reliably deliver extra volatility—but not often extra returns.

I then addressed two strategies for following Sharpe’s suggestion. The first approach is to buy a leveraged exchange-traded fund. Several of them hold the S&P 500. Unfortunately, those funds are supercharged, being at least 100% leveraged (meaning that $1 of invested capital controls $2 of assets). That is rather more than I had intended. Also, those funds are designed for short-term traders, being rebalanced daily. My interest is a long-term strategy.

The other method I discussed for achieving leverage was the one-time act of borrowing at the time of purchase. For example, rather than invest $10,000 into an S&P 500 fund, the investor would take out a $3,000 loan (to be repaid in the near future) and invest $13,000. However, that tactic does not involve leverage, properly speaking. It is instead the mirror image of dollar-cost averaging, in that it accelerates the investment action, instead of spreading it out over time.

Last week's column concluded by stating that while daily rebalancing was too frequent, and leveraging once and then never again was not enough, there probably was Goldilocks solution: rebalancing periodically. After the column was published, I tested that proposition.

To my great surprise, my thesis failed. A confession: Nearly always when this column contains a chart or table, I know what the numbers will show before I do the work. If I did not, I would publish far fewer columns, and spend more time wandering down blind alleys, running spreadsheets that resulted in null findings. Fortunately, as I have been around since forever, my instincts are such that I mostly avoid such predicaments.

Not this time. This thesis that leveraging the S&P 500 could make sense, at least in some circumstances, did not check out, even though I rigged the trial so that it would. I leveraged the S&P 500 by 30%, so that $1 of capital commanded $1.30 of assets, during the great bull market of 1985-2017. Naturally, I expected to see results to be favorable. I then planned to offset this good news by showing how leverage cuts the other way during bear markets. Pros and cons. Yin and yang. So I thought.

Generous Terms The initial spreadsheet was straightforward. Assume a 130% position in the S&P 500 on Jan. 1, 1985. Calculate the monthly change in this portfolio by multiplying the S&P 500's total return by 1.3. At month's end, assume that the investor adjusted the size of his loan, so that the leverage ratio remained unchanged—a constant proportion of $1.30 invested for each $1 of capital. To witness leveraging in its best possible light, albeit unrealistically so, assume no borrowing cost. That money came for free.

I will say this: Leveraging under these highly generous (and unavailable) terms does indeed beat the plain-vanilla S&P 500 portfolio, over a long bull market. How could it not? One dollar invested in the Vanguard 500 Index Fund grew to $34.71 over those 33 years, for an average annualized return of 12.4%. For its part, after repaying its loan at the end of the time period (otherwise the two portfolios aren't comparable), the 130% leveraged portfolio that was financed with free money grew to $86.40 -- a 16% annualized result.

Well, that seems to work. However, as we will see in the next column, that result was accompanied by fearful volatility. I fancy myself braver than most investors, being 95% invested in equities, but I'm not sure that I could have held that portfolio through the toughest of times.

Besides the free-money assumption, I tossed the leveraged portfolio another bone. The simulation assumes that it, like the unleveraged portfolio, neither sells shares along the way nor requires additional cash outlays. However, that is not correct. Because of the requirement that the leveraged portfolio maintain a constant equity exposure of 130%, one or the other must occur. A monthly S&P 500 loss would force the investor either to sell shares, or to pay down a portion of the loan. Otherwise, the loan-to-equity ratio would be too high, and the 130% leverage percentage would be breached.

Real-World Costs Of course …money is never free. I then raided the Federal Reserve Bank of St. Louis's database (FRED), downloaded the monthly federal-funds interest rate, and simulated three borrowing costs. I permitted institutions to borrow at the fed-funds rate plus 2 percentage points; larger retail investors ($1 million), at fed-funds plus 4 points; and small retail buyers at fed-funds plus 6 points. (I couldn't find a database that listed historical margin-account interest rates, but based on current quotes, those assumptions seem roughly correct.)

After accounting for interest costs and repayment of the loans in December 1987 (although not the occasional cash outlays during the time period), the cumulative returns for the three leveraged portfolios were:

Institutional $60.36 Large Retail $49.60 Small Retail $40.76

The institutional total could be regarded as acceptable. It is not final without considering the effect of the periodic loan repayments (perhaps I will get that work done by the time of the next column), but an ending value of $60.36 vs. $34.71 for the unleveraged portfolio is a significant difference -- particularly for an institution such as an endowment that might have an indefinitely long time horizon. However, the retail results are insufficient. The victory margins are too small, considering they occurred over the best of all possible investment worlds, and carry so much additional volatility.

My expectations were confounded. I had thought that with this column, I would argue that under certain circumstances, for certain investors, that leveraging a stock-market index might make sense. After reviewing the numbers, I will not do that. Next column, we'll look at why the numbers came out as they did. What had I not anticipated?

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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