Most people think of leverage as the root of all evil, high risk and that it must be eradicated before any more damage can be done – e.g. the financial crisis of 2008. But as everyone knows, “guns don’t kill people, people do”, and the same goes for leverage. To be clear, we are NOT advocating gun control or the right to bear arms. As a matter of fact, we have no opinion on anything, politically or otherwise. Nevertheless, the point is this, leverage at the end of the day is just a tool. If used badly, yes it can cause a lot of havoc, but if used as part of a sound investment strategy, leverage is an ingenious means of creating value.
So let us explore leverage in a bit more detail and with an open mind. Let’s say we think Vodafone will go up, so we buy £1m in shares. What’s our risk? Assuming the stock goes up or down by 1% every day, you could make an argument that the daily risk of this position is £10k. If we now leverage this position by say 10 times, e.g. we borrow £9m and then buy more Vodafone shares, our risk would be £100k. And please note that we are highly simplifying this here, as you would of course have to pay someone a fee for borrowing the money and you would also have to put up some sort of security, but we are making a point here. Consider the tail risk involved when buying Vodafone shares, because of course, Vodafone doesn’t only ever go up and down 1%. During 2008 for instance, the stock went down 50%, which means the risk of our leveraged position would actually be £5m (£1m * 50% * 10). That’s scary, and anyone would clearly see that leverage is not a good idea here.
But what about if we hedge? Let’s say that we are right about Vodafone and it will outperform the market. After all, why else buy the shares? If you then hedge our £1m share position and sell (short) an equal amount of FTSE 100 futures, what would our risk be then? That has to do with correlation and the tendency of Vodafone to move in line with the market. Again not wanting to split hairs and trying to make a point, let’s assume the correlation is 80%. That means that the risk of holding £1m in Vodafone shares and also holding £1m in short FTSE futures is now £2k (as we have hedged away 80% of the £10k in risk). Would you now leverage this position by 5 times and have the same risk as just holding £1m? Maybe, but the really huge difference is this: If we have a market crash, you will lose much less if you also hold a short position in FTSE futures. And that makes holding a leveraged (and hedged) position in Vodafone much lower risk than holding the shares outright.
In the arbitrage world, where we look for mispricings in securities that have a much higher correlation (such as an index – cash versus futures), leverage has been a tried and tested tool. In fact, most good index arbitrage desks in the mid-nineties were probably using 100 times leverage, never had a losing day and printed money until one day others figured out the game and slowly the arbitrage disappeared. It was pure beauty when it worked and unfortunately, such opportunities are much harder to find these days. But if you do find a great trade, wouldn’t you want to do more and not less if you can take the risk?