Leverage

June 2021

In an environment of exceedingly low rates and historically low expected returns, investors are trying to find new ways to meet return expectations. One approach they may consider is actually quite old: the use of borrowed funds, or leverage. By using leverage, an investor can move beyond the constraints of the traditional efficient frontier in order to amplify their gains. However, leverage can also magnify losses and may introduce new risks to the portfolio.

What is leverage? At its core, leverage is the use of borrowed funds to make an investment. In other words, it is the debt-financed purchase of an asset (or a derivative of an asset). While our focus is on the use of leverage in investment portfolios, leverage is itself ubiquitous. Most companies use borrowed funds to finance projects, cover operating expenses, and accelerate growth. Using a mortgage to buy a home is an explicit form of personal leverage. In financial markets, participants can take advantage of a number of instruments and tools to create levered asset exposure. Doing so magnifies investment gains as well as losses. For leverage to be profitable, the asset in which the borrowed funds are invested must produce a rate of return that exceeds the cost of borrowing. Leverage can be achieved through explicit borrowing or investment in securities that facilitate leverage (e.g., derivatives).