Leveraging an investment (what we in the UK call ‘gearing’, or borrowing money to invest) is a risky practice.
In a rising markets it can boost investment returns, assuming the rise in investment values more than covers the cost of servicing the debt.
In falling investment markets it can quickly magnify losses.
Most retail investors in the UK will only ever experience gearing through commercial property fund investments.
This important investment asset class often involves the fund manager borrowing money to leverage the size of their investment portfolio, usually with reasonable results over the long term.
It does occasionally go wrong with leveraged property investments, as we have seen with a number of unregulated collective investment schemes (UCIS) funds exposed to property following the global financial crisis.
Where funds could not refinance their debt at acceptable rates, or at all in some cases, liquidity in these esoteric funds dried up, projects could not be completed and investors swallowed massive losses.
But leaving these dodgy unregulated property funds to one side (as the majority of retail investors should not touch them with a bargepole, under any circumstances), where else does leveraging or gearing create risks?
The US Federal Reserve is concerned about the risks associated with increasingly popular leveraged Exchange Traded Funds (LETFs).
In a report published last month, a researcher from the Fed concluded that a “1% increase in broad stock-market indexes induces leveraged ETFs to originate rebalancing flows equivalent of $1.04 billion worth of stock.
“Price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks.”
In slightly simpler language, the mere existence of leveraged ETFs could harm financial markets in the event of another ‘flash crash’ or sudden market movement.
A leveraged ETF is a fund that uses financial derivatives and debt with the aim of boosting the returns of an underlying index.
This does not amplify the annual return of the index, but rather the daily change in index value.
This approach can sometimes confuse investors who expect to see two or three times the annual change in the S&P 500 index, for example, but instead see a very different return from their leveraged ETF.
It is good to see the Fed raising the issue of these risks with leveraged ETFs, as they apply to UK investors as well as those in the US.
As with unregulated investments, the vast majority of UK retail investors have no business investing in leveraged ETFs.
They are primarily designed as trading vehicles, rather than funds to buy, hold and then eventually sell.
Unleveraged ETFs which use full physical replication, rather than synthetic strategies, can have a place for retail investors, assuming the features, benefits and risks are fully understood.
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