Borrowing to boost returns: too much of a gamble for investors?

Some products, including investment trusts and ETFs, allow investors to amplify returns through leverage, but the risks can outweigh potential rewards.

Borrowed capital can amplify investment returns. If you invest £1,000 and see a 10% return, you will receive £100 in profit. If you leverage your investment by borrowing £9,000 to add to your existing £1,000, you will have £10,000 to invest and that same 10% return will yield £1,000.

However, because 90% of what you have invested is borrowed, the return on your initial £1,000 is 100%. Leveraging has enabled you to double your money (excluding borrowing costs).

The problem, however, is that while borrowing boosts returns when an investment goes the right way, it exacerbates losses when the investment goes awry.

Justin Modray at Candid Financial Advice says: “It’s great to have when markets are rising, but it will increase your losses when they fall.”

That’s why almost no one advises private investors to borrow to invest in this way. Nevertheless, several investment products allow investors to gain the amplified returns borrowing provides: primarily leveraged exchange traded funds (ETFs) and to a lesser degree investment trusts that employ gearing.

Leveraged ETFs

Exchange traded funds are a popular way to access leverage. Modray says: “Instead of borrowing, these funds strike deals with other parties, usually banks, to provide a given return, perhaps two or three times the rise or fall in a specific index.” The results, though, are the same as with conventional borrowing: amplified losses and gains.

For example, the WisdomTree Silver 2x Daily Leveraged ETC aims to provide double the return from the Bloomberg Sub Silver index. If the index rises by 5% in one day, the fund should go up by 10%. Conversely, if the index drops by 5%, the fund should fall by 10%.

That’s why anyone buying such an ETF needs to be confident that the market will go the way they expect it to. For those who have used equity-focused leveraged ETFs over the past decade, the bull market may have produced strong, once-in-a-lifetime returns.

In his book Wall Street Bets: How Boomers Made the World’s Biggest Casino for Millennials, Jaime Rogozinski recounts how in 2010 one user in his online investment community invested $170,000 (£157,109) in two ETFs: Direxion Daily Financial Bull 3X Shares, which aims to provide three times the return from the US Russell 1000 Financial Services index, and Direxion Daily S&P500 Bull 3X Shares, which targets three times the return from the S&P 500 index. The investor closed his trade in December 2019 for $1.7 million.

With hindsight, betting on a strong recovery in the US economy and banks seems an obvious winner, so using leverage to maximise the gain from a rising market looks an acceptable risk. Hindsight, of course, is a marvellous thing. In reality, the user took a huge risk in betting such a large amount on an uncertain outcome.

- Explore our articles on ETFs

More risk

The role of luck when investing in these products should not be discounted. Rogozinski writes that the investor in question admits that he feels “very lucky to have not lost everything”. Had the market gone the other way, such a risky investment would have been disastrous.

Kenneth Lamont, a senior research analyst at Morningstar, says: “These products increase risk. Even small market movements can cause large losses – or gains. And generally, investors just aren’t that good at predicting which way the market will go.” He adds: “Our research shows that investors are extremely bad at market timing, resulting in poor investment returns over longer periods.”

Lamont also makes the point that the enhanced volatility that comes with leveraged ETFs can damage returns. Say you invest £10,000 in a fund with double leverage and the market falls by 40%. You have doubled your losses and are down 80%, leaving you with just £2,000. Had you been in a non-leveraged ETF, you would still have £6,000 left.

Being a buy-and-hold investor, you wait for the bounce-back. However, because of the large initial fall, it is much harder to get back to your starting point. Lamont says: “Assume there is hugely bullish news the next day and the index rises by 60%. The unleveraged fund is now worth £9,600, almost back to break-even. The leveraged fund soars by double the index rise, a full 120%, but that leaves you with just £4,400. In this scenario, investors would have been much better off simply buying an index tracker. They would have received higher returns with substantially lower volatility.”

Given all the risks, most market commentators discourage the use of leveraged ETFs. Lamont says: “Given the complexity and elevated risk profile of these products, we do not think they are suitable for most retail investors.” Josh Brown, chief executive at Ritholtz Capital Management, sums it up neatly: “The words ‘investors’ and ‘three times leveraged’ should never appear in the same sentence.”

- Investment trust gearing levels were ‘modest’ heading into market sell-off

Trusty options

While leveraged ETFs are seen as high-risk and, typically, unsuitable for private investors, leveraged investment trusts are more acceptable. Trusts can borrow money from banks to amplify their gains. This is known as gearing, which is expressed as a percentage of the net asset value of a trust. While leveraged ETFs borrow substantially to increase returns – or losses – by multiples, investments trusts usually deploy much less leverage.

Excluding venture capital trusts, 46% of investment companies were geared as at December 2019, according to data provided by the AIC, but the average level of gearing was just 7% of NAV. Gearing limits are set by boards and vary widely. Scottish Mortgage, for example, caps borrowing at 10%, while Henderson Higher Income can go up to 40%. According to the AIC, the median upper gearing limit for equity-focused trusts is 20%.

An ability to boost returns through gearing has been a big selling point for trusts competing with open-ended funds in recent years. However, as Jonathan Miller, head of UK manager research at Morningstar, notes, with markets recently seeing huge sell-offs, some trusts have only managed to amplify their losses. He says: “We have had a decade of generally rising markets, so gearing has been a strong driver of returns. But in a sell-off, it’s losses that are driven up.”

That is not to say geared investment trusts have no place in investors’ portfolios, however. Gearing has added value for long-term shareholders, according to Simon Crinage, head of investment trusts at JPMorgan. He says: “Equity, bond and commodity markets have increased in value over the long term. Managers who successfully deploy gearing see this growth amplified over time.”

He adds that while gearing will not add value for shareholders during crises, these are generally short-lived. Over the long term, markets tend to rise. Historically, whenever managers maintained their gearing in tough times, the returns generated over time were greater.

For investors willing to take some additional short-term risk to amplify their returns using debt, investing in a geared investment trust run by an experienced manager is probably the safest option.

Modray says: “Gearing can be used to boost your investments in rising markets provided you can tolerate the pain when they fall.”

- Ask Money: does borrowing to invest make sense?

Quantifying the gearing gamble

In the table we compare some geared investment trusts with their most comparable open-ended funds from the start of 2020 to 1 April.

The open-ended funds have similar portfolios and the same manager, but do not use gearing. To ensure market falls have not exacerbated gearing levels, we used gearing figures as at 2 January 2020. (Gearing increases as a proportion of NAV as the value of the underlying portfolio falls.)

As can be seen, most of the trusts with higher gearing have experienced notably greater falls. Morningstar’s Jonathan Miller notes: “Even moderate gearing has accentuated performance on the way down, so highly geared trusts have been hit particularly hard.”

In comparison, the lowly geared Finsbury Growth & Income has almost the same return as its open-ended equivalent.

Geared trusts and open-ended funds compared

Note: Table shows total returns for geared investment trusts compared with equivalent open-ended funds.*Gearing level as at 2 January. Source: FE Analytics, 2 January to 1 April 2020