We all know that the UK and US stock markets have risen over the past 50 years. It would therefore seem intuitive to think that leveraging these markets would have generated higher returns. No so.

We investigate the relationship between financial leverage and stock market returns over the long-term.

The use of leverage is intended to capture price movement greater than the market, typically accomplished through derivatives trading to mimic the return characteristics of an underlying index. Leveraged investment vehicles are widely distributed in exchanged traded fund (ETF) format and these strategies are commonplace within hedge funds via derivatives markets.

A leveraged strategy intends to deliver a multiple of the underlying indices’ daily (or in rare cases monthly) return. However, over the long-term this does not translate into any reliable multiple of the performance of the underlying index. The chart below illustrates this. The log cumulative return of the S&P 500 has actually outperformed its twice-leveraged counterpart over the past 144 years since 1871. And this is before fees and additional costs are deducted.

Source: Dr. Robert Shiller, Morningstar, Cerno Capital

The reason lies in compounding, where its effect is magnified by leverage. So while a leveraged index tracks well on an intraday/daily level, divergences will begin to appear over a longer horizon. Leveraged returns are highly path-dependent. In particular, downside risk could be exacerbated during periods of high volatility.

Consider a leveraged investment with an initial value of 100. We examine the simple return dynamics over a period of five trading days under three different scenarios:

When the index performance is trending in one direction, whether up or down, leverage tends to enhance performance.

Trending Up

Day 0

Day 1

Day 2

Day 3

Day 4

Day 5

Performance

Daily Change

 

+5%

+10%

+5%

+10%

+5%

 

Index Value

100

105.0

115.5

121.3

133.4

140.1

+40%

2x Leverage

100

110.0

132.0

145.2

174.2

191.7

+92%

3x Leverage

100

115.0

149.5

171.9

223.5

257.0

+157%

Source: Cerno Capital

Trending Down

Day 0

Day 1

Day 2

Day 3

Day 4

Day 5

Performance

Daily Change

 

-5%

-10%

-5%

-10%

-5%

 

Index Value

100

95.0

85.5

81.2

73.1

69.4

-31%

2x Leverage

100

90.0

72.0

64.8

51.8

46.7

-53%

3x Leverage

100

85.0

59.5

50.6

35.4

30.1

-70%

Source: Cerno Capital

However, when index performance is volatile, leverage tends to exacerbate loss.

Volatile

Day 0

Day 1

Day 2

Day 3

Day 4

Day 5

Performance

Daily Change

 

+5%

-10%

+5%

-10%

+5%

 

Index Value

100

105.0

94.5

99.2

89.3

93.8

-6%

2x Leverage

100

110.0

88.0

96.8

77.4

85.2

-15%

3x Leverage

100

115.0

80.5

92.6

64.8

74.5

-25%

Source: Cerno Capital

But in all cases, over a longer period, leverage does not perform as expected. Leveraged outturns do not describe a linear relationship as the product of return times leverage factor. Unless the investor has great confidence in the consistency of the market’s future trajectory (and in our opinion, this means beyond what can reasonably be known), leverage is unadvisable as the market is rarely without fluctuations for a prolonged horizon. Leverage is essentially a volatility position by construction. In many cases, even if the market moves in the anticipated direction, one may still end up with a loss if volatility is high. The chart below illustrate this point, leverage underperforms whenever volatility spikes.

Source: Dr. Robert Shiller, Morningstar, Cerno Capital

Taking the entire S&P 500 series from 1871 to present, we found that on a monthly basis, over any 12 month period, 2x leverage outperformed the index 55.5% of the time. However, as we increase the horizon, the outperformance gradually decreases to only 35.8%.

Despite a shorter history, a similar pattern emerges when we look at data for the UK equity market for the period 1962-present.

Source: Bloomberg, Cerno Capital, Valu-Trac

Over any 12 month period, 2x leverage outperformed the index 60% of the time. But this ratio declines as the horizon stretches to 3 years (52.4%), 5years (50.6%), 10 years (42.6%) and 30 years (39.3%).

Another potential drag on returns for a long-term investor comes from the high cost that is often associated with a leveraged strategy. These are more expensive than a traditional long-only strategy as they must takes into account the i) capital gains/losses of the underlying market; ii) financing cost to lever the portfolio (and for holding derivatives); iii) transaction/rebalancing costs; and iv) liquidity spread (additional cost of sourcing long-term liquidity). These all contribute toward a high net expense ratio.

A leveraged strategy mostly appeals to short-term traders with a high risk tolerance when making directional bets. Due to its path-dependent nature, it will perform well when the market exhibits strong momentum with a relatively stable upward or downward trend (provided the direction is correctly called).

Financial market commentator James Montier of GMO, on whose observations this work is based, has always been a strong opponent of using leverage, citing one of the key financial risks to be ‘asset + leverage’. To reiterate, leverage can be a used as a speculative expression of directional views across different asset classes over the short-term, but it can also be a big destroyer of value over the long-term from both risk and cost perspectives, and therefore not suitable vehicles for ‘buy-and-hold’ investors.

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