Leveraging Investment returns if you are not Warren Buffet and you do not own an Insurance company

This post was inspired by an interesting paper which explores how much of WBs success is attributable to leverage.

The authors calculate that Buffet applied (mostly through his insurance float and debt a leverage ratio of between 1.4:1 to 1.6:1 over the life of Berkshire.I would speculate that this might be even higher if one factors in his sales of S&P puts and CDS protection.

However, for the ordinary investor it is quite difficult to gain access to cheap insurance float and the AAA funding cost Warren Buffet enjoys.

So what are the alternatives for “normal” investors ?

For the discussion of leverage and to show some quantitative examples,I will use the following series of returns:

Returns    
  Portfolio DAX
2001 -17.50% -19.79%
2002 -35.50% -43.94%
2003 33.50% 37.08%
2004 12.70% 7.34%
2005 30.06% 27.07%
2006 19.50% 22.00%
2007 37.30% 22.30%
2008 -13.58% -40.40%
2009 49.30% 23.85%
2010 36.97% 16.06%
2011 -4.10% -14.69%
2001-2011 p.a. 10.15% -0.79%

1. Leveraging up with a simple loan

This is the easiest and most often used form of leverage for retail investors. Basically one could achieve this in two “flavours”:

– opening a margin account, where the brokers requires only to put up a certain percentage of the purchased amount of shares
– taking out a loan against an existing security portfolio and reinvest this into additional securities

However this form of leverage has some disadvantages:

– implicit costs are relatively high (for instance brokers charge 5-6% for the loans
– the leverage is not “permanent” as the brokers will terminate the loan if the value of the collateral declines below the value of the loan

Just as an example,look at how the returns of my sample series would look under different “leverage” ratios (assuming a constant cost of a loan of 5% p.a.) both for 1.4:1 and 1.6:1 leverage:

Returns      
  Portfolio 1.4:1, 5% 1.6:1, 5%
2001 -17.50% -26.50% -31.00%
2002 -35.50% -51.70% -59.80%
2003 33.50% 44.90% 50.60%
2004 12.70% 15.78% 17.32%
2005 30.06% 40.08% 45.10%
2006 19.50% 25.30% 28.20%
2007 37.30% 50.22% 56.68%
2008 -13.58% -21.01% -24.73%
2009 49.30% 67.02% 75.88%
2010 36.97% 49.76% 56.15%
2011 -4.10% -7.74% -9.56%
2001-2011 p.a. 10.15% 10.03% 9.34%

Clearly, the with this return series and the 5% cost for the loan, simple leverage does not create additional performance after 11 year but adds a lot of volatility. Interestingly, a 1.1:1 leveraged portfolio would have performed slightly better (10.26% p.a. against 10.13%) than the original portfolio.

2. Using derivatives

Especially in Germany, investors crave derivatives which mostly come in the form of bank issued traded options, CFDs etc. In my opinion all those instruments have significant disadvantages such as:

– issuer counterpart risk (anyone remembers Lehman ?
– high implicit risk through high bid ask spreads
– usually hidden features which normal investors can’t really price (knock out, treatment of dividends) etc.

Practically, for an “off the beaten path” investor like me there are no instruments available anyway which cover the stocks I would like to invest in. Other practical problems include that in times with high volatility, often those instruments don’t trade at all as one is usually dependent on the issuer to make a market.

To a certain extent, single stock futures traded on exchanges could mitigate some of the issues above, but they didn’t really take of and few are available.

3. leveraged ETFs

When the banks start to offer leveraged ETFs (I think Lyxor was first with the 2x leveraged DAX ETFs), many people including yours truly though that this is a simple tool to cheaply lever up investment returns.

However the daily reset of the leveraged ETFs lead to anything but the double performance as we could see if we compare the 2 times leveraged LevDax ETF against the underlying DAX:

The problem is the daily reset of those products as they only mimic daily performance and those products do not multiply long term performance as this WSJ article points out. So no free and easy leverage here.

4. Leverage through a long short strategy

With a”real” short sale, one effectively conducts two different transaction:

a) borrowing a security
b) selling the borrowed security

As a result you have received the cash but have the obligation to uy back the share at some future point. So in contrast to a derivative, you can reinvest the proceeds and lever up your portfolio.

The “cost” of the short can also be split into 2 components:

I) “borrowing” fee, this is usually relatively cheap unless you short special securities (let’s assume 1%)
II) the underlying performance of the shorted securities including dividends, coupons etc.

So point II) is clearly the decisive factor in any long short strategy. Of course shorting single stocks sometimes leads to quite significant volatility as anyone who still remembers the Volkswagen corner can easily testify.

Another relatively cheap and “secure” alternative to short single securities is shorting ETFs, especially Index ETFs.

So let’s look at our sample returns, “leveraged” up by a 40% and 60% DAX ETF short,costing 1% op.a.:

Portfolio DAX 1.4:1 DAX short, 1% 1.6:1 DAX short, 1%
2001 -17.50% -19.79% -16.98% -16.73%
2002 -35.50% -43.94% -32.52% -31.04%
2003 33.50% 37.08% 31.67% 30.75%
2004 12.70% 7.34% 14.44% 15.32%
2005 30.06% 27.07% 30.86% 31.25%
2006 19.50% 22.00% 18.10% 17.40%
2007 37.30% 22.30% 42.90% 45.70%
2008 -13.58% -40.40% -3.25% 1.91%
2009 49.30% 23.85% 59.08% 63.97%
2010 36.97% 16.06% 44.93% 48.92%
2011 -4.10% -14.69% -0.26% 1.65%
2001-2011 p.a. 10.15% -0.79% 13.80% 15.58%

So “Heureka”, we found an easy way to leverage returns through this ? Also the standard deviation of the leveraged portfolio is only slightly higher than the original series.

But be careful !! The original series is a performance series which has an average outperformance of ~10.5% p.a. against the DAX or in investment speak “alpha”. Leveraging with a short position does only increase returns if you have positive alpha greater then the borrowing cost !

If you don’t have alpha on the long side, the short index will LOWER your returns.

5. Managing other people’s money with performance fees

So finally let’s look at how Buffet initially started out, his original partnership:

I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited.

In order to mirror Buffets Partnership, we assume the following: We have third party money in the same amount as our own money. This leads to the following performance for ourself:

Returns      
  Portfolio 1 Profit share Total
2001 -17.50% -4.38% -21.88%
2002 -35.50% -8.88% -44.38%
2003 33.50% 14.75% 48.25%
2004 12.70% 4.35% 17.05%
2005 30.06% 13.03% 43.09%
2006 19.50% 7.75% 27.25%
2007 37.30% 16.65% 53.95%
2008 -13.58% -3.40% -16.98%
2009 49.30% 22.65% 71.95%
2010 36.97% 16.49% 53.46%
2011 -4.10% -1.03% -5.13%
2001-2011 p.a. 10.15% 6.62% 14.40%

If we look at someone who manages to attract “other people’s money” 5 times his own investments, returns even look nicer:

Portfolio 1 Profit share x5 Total
2001 -17.50% -21.88% -39.38%
2002 -35.50% -44.38% -79.88%
2003 33.50% 73.75% 107.25%
2004 12.70% 21.75% 34.45%
2005 30.06% 65.15% 95.21%
2006 19.50% 38.75% 58.25%
2007 37.30% 83.25% 120.55%
2008 -13.58% -16.98% -30.56%
2009 49.30% 113.25% 162.55%
2010 36.97% 82.43% 119.40%
2011 -4.10% -5.13% -9.23%
2001-2011 p.a. 10.15% 25.18% 21.36%

In modern times, such a structure would rather look like the following: 20% performance fee with “high Watermark”, no downside participation.

Our sample return series with such a structure and 5 x times outside capital looks like that:

Portfolio 1 Profit share x5 Total
2001 -17.50% 0.00% -17.50%
2002 -35.50% 0.00% -35.50%
2003 33.50% 0.00% 33.50%
2004 12.70% 0.00% 12.70%
2005 30.06% 4.13% 34.19%
2006 19.50% 19.50% 39.00%
2007 37.30% 37.30% 74.60%
2008 -13.58% 0.00% -13.58%
2009 49.30% 35.72% 85.02%
2010 36.97% 36.97% 73.94%
2011 -4.10% 0.00% -4.10%
2001-2011 p.a. 10.15% 11.08% 19.28%

Interestingly, there is new German “social media” website called wikifolio.com, which would allow to set up a master portfolio, into which other people could invest through traded certificates.

The structure allows for charging performance fees. However, the choice of investments seems to be relatively limited and the total cost for the “followers” relatively high. Nevertheless it still looks like a very interesting idea.

Summary:

As a private investor, it is very difficult to gain access to the kind of leverage Warren Buffet enjoys through his AAA rated insurance company. This is definitively part of Buffets “mojo” or “secret sauce” which cannot be easily copied.

For a private investor, either shorting index ETFs or attracting 3rd party money through a partnership structure might be the only way to “safely” leverage up investment returns.

12 comments

  • Apropos Wikifolio: Did you ever think about the possibility to create a wikifolio of your current blog-portfolio? I would seriously think about bying some of these certificates…

    • I did look at that. However the cost and the profit share of the issuer are too high.

      Additionally, especially with illiquid stocks, I think there is a risk that you might end up with “unwanted outcomes”. And I think that many of the stocks I own do not work for Wikifolio.

  • @mmi:
    “they increase your losses” – invalid every exposure can increase your losses, including short index positions.
    “you have to bear the opportunity cost” – invalid every exposure involves opportunity cost
    “you are forced to buy” – invalid it is no difference if you are forced to buy or if you had already bought enabled by borrowing.

    Writing put option enables you to get stock exposure if your funds are not sufficient, and in this way sort puts are very similar to other forms of leveraging. In my opinion there is no valid point against put options which does not hold in the exact same manner against leveraging in general

  • #robert,

    i had this argument about short puts already several times. In my opinion they are “bad” lveregae because:
    – they increase your losses (in contrast to a short index position)
    – you have to bear the opportunity cost
    – you are forced to buy

    Buffets multy year put option is maybe better, but not obtainable for a private investor.

    mmi

  • @mmi: A black swan event is only a problem if you are not willing to hold the delivered assets, if you are willing to hold you can just sit the downturn out. In my opinion short puts are very similar to stocks. The biggest disadvantage is the limited upside change, the greatest advantage the reduced need for capital.

  • #shob, your calculation is not fully correct. in order to maintain a constant 1:4:1 short ratio, you have to short a lot more than 40 EUR in the later years. In the last peried for instance you aremore like shorting 120 EUR with the respective interest charge. But I will still have to check my formulas.

    mmi

  • I think the numbers in the table 2 (unleveraged vs. leveraged 1,4:1, 5%, etc.) are wrong or misleading.

    If you take 100 and make up an excel-sheet with your given performance numbers for the 11 years, you have an end amount (Endwert) of 290,75 Euro.

    If you take 100, and add antoher 40, for which you pay 2 Euros as interest at the end of every of the coming years (2/40 = 5%), you have 349,55 Euros at the end. Minus the borrowed 40, you get 309,55, more than in your unlevereraged scenario. The performance you get for your own invested capital is better than in the unleveraged szenario, not worse, as table 2 indicates it with a return of only 10,03% vs. the 10,15%in the unleveraged scenario.

    This must be the case, as long as the invested capital, over the long run, brings a higher p.a.-performance (before interest) than your borrowing costs. Thats the core of the leverage effect.

    In concrete, your advantage in the leverage szenaorio is exactly (10,15% – 5%) for the additional invested 40 Euros and that for 11 years. That sums up to 29,50 Euro
    (40 * [1+0,1015-0,05]^11)-40
    That is the difference between the 309,55 and the 290,75= 29,50.

    Of course, your return on your own invested capital will be boosted as long as your returns are higer than the borrowing costs. It not just adds a higher volatility.
    In fact, I am leveraging my investments now for over 10 years for credit costs of about 5-6% (Ratio: 1,1 – 1,5: 1) and that has boosted my performance by a large amount.

    • #robert, yes the “trick” works but you need of course a beginning balance. Many brokers allow the margin to be posted as securities (with a haircut).

      Selling put optionns in my opinion is a really bad idea because for a little premium you are short a “black swan” event.

      mmi

  • Does the shorting trick really work? I thought that the cash you gain is locked, to provide security to the borrower.
    Don’t omit derivatives too fast. If you search long enough you can find spread close to 1% You don’t get the dividend, but you don’t get one with black-scholes valued options either. Possible the best way to leverage is to short long-term puts.

  • Hi Martin, thanks for the comment.

    Re ETF: Most ETFs offer “virtual units” which can be shorted. It is a somehow complicated process but ensures that you don’t really have to borrow. That’s why hedgefunds love it. There were quite a lot of articles on FT Alphaville.

    Real estate: Yes, that would be a possibility. Are you sure you can leverage up und use the proceeds for something else ?

    MMI

    • Yes depending on your collateral, but this kind of credit has disadvantages:
      – you can’t cancel without paying compensation to the bank
      – there are cost for the notary
      – interest rate is not tax deductible in Germany, unless you incorporate the whole thing

  • What if the lender of the ETFs you are shorting want’s them back?

    An alternative for people with real estate could be a cheap annuity loan with no amortisation. In Germany you can get under 3% p.a und use this to leverage returns. The interest could be paid from income. Although I wouldn’t dare to leverage more than 1.1:1

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