The Power and Peril of Levers

“Give me a lever and I will move the world.”

Photo: Jon Hrusa, USAID Source: Pixnio. Public Domain

That’s what Archimedes said when he was explaining the power of leverage. Leverage takes our strength and multiplies it. It makes it possible for small kids and big kids to play on the same seesaw. We use levers in our toolbox: pliers, wire cutters, screwdrivers. Leverage is the principle behind pulleys, engines, and most of the innovations of the industrial revolution. Some physicists with extra time on their hands calculated that Archimedes lever would need to be 11 light-years long for him to “move the world.” By comparison, the Andromeda Galaxy is about 2.5 light-years away.

Leverage is incredibly powerful. Its use in corporate finance is well-documented. A company with a 50% debt-to-equity ratio is levered 2-to-1. This financial leverage allows them to create higher returns on their equity. The drug company Pfizer is levered 2:1. This allowed them to turn a 6% return on their assets into a 12% return on equity in 2018. Most banks are levered 10:1. That allows them to turn a 1% return on assets into a 10% return on equity. Of course, leverage is a knife that cuts both ways. If a company is highly levered, it may not be able to make its loan payments during a slump. We experienced this first-hand during the Global Financial Crisis a decade ago.

The same principle works for entire economies. After the Financial Crisis, several countries in the Eurozone – Greece, Ireland, Italy, and others – were highly levered and were seeing weak recoveries. It was clear that some of them wouldn’t be able to pay their debts, and there was some speculation that they might leave the Eurozone, or that the Euro might even fail. Leverage helped them grow faster during the pre-crisis boom, but it made their downturn worse.

Source: Pixabay. CC0.

And the principle applies to investing as well. If an investment portfolio returns 6%, a modestly levered (say by a tenth) portfolio can return 6.5% after subtracting borrowing costs. The lure of leverage is simple. Who wouldn’t want higher returns? It seems like a free lunch.

Of course, there’s no free lunch. A levered portfolio is more volatile than an unlevered portfolio. Below is a total return graph of the performance of a levered portfolio of investment-grade bonds, compared with an unlevered aggregate. The fund was levered about 1.3 to 1. Over the last 16 years, the levered fund returned 5% per year while the Aggregate returned 4%.

Source: Bloomberg

Leverage didn’t provide a free lunch by any means. The levered fund fell by about 50% during the Financial Crisis, and by over 40% during the Covid crisis. If you had purchased this fund in a brokerage account on margin (multiplying leverage with leverage) you would have been wiped out. Leverage increases returns, but also it multiplies risk.

But the lure of leverage is always there. In the late ‘90s, some well-regarded traders and Nobel Prize-winning economists analyzed credit strategies that seemed extremely consistent. The strategy returned 1% on assets; they levered it 25 times to get a 25% return on equity. We know how the story ended: Long Term Capital Management was the first big Fed-orchestrated bailout for the lenders of a highly-levered institution. But it certainly wasn’t the last!

The use and abuse of leverage reminds me of a proverb: “When you find honey, eat just enough. Too much, and it won’t be pretty.” (Pb. 25:16). The temptation to overdo something sweet is clear. Stable markets invite more leverage. Some is good; more is better. Participants use some, they get good returns, so they use a little more. That becomes addictive – until volatility comes back, and they lose everything. This phenomenon is behind most of the high-profile hedge fund failures of the past 20 years. It’s so significant that many institutions prohibit the use of leverage or leveraged products.

Photo: Steve Buissine. Source: Pixabay.

Still, just because a tool is dangerous doesn’t mean we just throw it away. Power tools are dangerous, but if I know how to use them they make my work around the house a lot easier. There are times and places for investors to use leverage. Some researchers reviewed Warren Buffett’s investment practice and noted that he applies about a 1.6 to 1 ratio to his portfolio holdings. This is part of the reason Berkshire Hathaway has outperformed the S&P 500 by 4% over the past 30+ years. To be sure, he did a lot more than simply lever the index. But his leverage was certainly a material aspect of his portfolio’s performance.

Warren Buffett. Photo: Mark Hirschey. Source: Wikipedia

Everyday investors can’t get special loans or bailouts, but we do have access to leverage in other ways. Some brokers offer portfolio margin, where investors can borrow – at very low rates – based on the value of their total portfolio. Investors can access levered products like closed-end funds. And some instruments have leverage implicit in their structure. Futures and options are levered instruments that provide levered returns. That’s why they’re so tempting for individuals, and why so many novice investors “blow up” when using them.

An appropriate degree of leverage, under strict controls, is a tool – no worse or better than the manager who uses it. Archimedes may not have been able to travel past Andromeda, but he was right: leverage can move the world. And if we’re careful, it can help us reach our financial goals as well.