Whether direct or indirect, leverage is probably best avoided, Larry Swedroe says.
It’s well known that many institutional and individual investors are either unable or unwilling to directly use leverage to increase their exposure to market risks. However, those same investors can increase their exposure to market risks by indirectly accessing leverage by purchasing products that have embedded leverage.
And there are many products—such as leveraged ETFs—that are specifically designed to provide embedded leverage. The benefit of embedded leverage is that it allows the investor to increase exposure to risks without either violating leverage constraints or risking a loss of more than 100 percent.
Given the negatives surrounding direct leverage, it seems logical that investment firms would be able to extract a premium for providing investors with products that have embedded leverage. Demonstrating the validity of this concept, while Vanguard 500 Index Fund Admiral Shares (VFINX) has an expense ratio of just 0.05 percent, Rydex’s S&P 500 2x Strategy Fund (RYTNX) has an expense ratio of 1.76 percent.
Of course, higher expenses negatively impact the risk-adjusted returns of such products.
Andrea Frazzini and Lasse H. Pedersen of AQR Capital tested this hypothesis in their research paper “Embedded Leverage.” They defined embedded leverage as the amount of market exposure per unit of committed capital. For example, the embedded leverage of a double-exposure times S&P 500 Index is two. Following is a summary of their findings:
- There was strong evidence that embedded leverage is associated with low-risk-adjusted returns.
- In each of the cross sections of equity options, index options and ETFs, securities with more embedded leverage offer lower-risk-adjusted returns.
- For each asset class, market-neutral portfolios that were long low-embedded-leverage securities and short high-embedded-leverage securities earned large and statistically significant abnormal returns with Sharpe ratios in excess of 1—and did so with large t-statistics.
Despite the poor returns provided by investment products with embedded leverage, many investors cannot resist the temptation. Thus, if you’re ever tempted to use embedded leverage, do as Ulysses did: Tie yourself to the mast so you can’t be tempted by its siren song.
Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.