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Leverage meaning

In most cases, financial leverage is the process of borrowing money in the form of debt to increase the potential reward from an investment opportunity.

The borrowed money is then used to buy additional shares in a company or to invest in a business opportunity with the hope the investment will increase profits.

In the investing world, leveraging is often called gearing which is common with investment trusts.

Borrowing to increase potential profits is a high-risk approach and very much a double-edged sword. On one hand, the value of your investments can climb rapidly if the market moves in your favour. On the other hand, any profits and your original investment can be cleaned out should things take a turn for the worse.

How does leverage work?

Leveraging can be a useful tool to help with achieving a financial milestone. For example, buying a first home.

When you buy a property, you’ll generally put down a deposit between 5%-25% of the purchase price from your own savings. The remaining amount is then borrowed from a bank through a mortgage. As the homeowner, you enter a leveraged position.

This might sound scary, but properties aren’t exactly cheap so it’s common for most people to take on debt to get onto the property ladder.

Borrowing money to purchase a home can work both for, and against you. If the value of the property increases, you can use the built-up equity to repay some of the mortgage. If the property price goes down, however, it’s possible to fall into negative equity – where the house could be worth less than the purchase price but the loan still needs to be repaid in full. It’s the risk of borrowing money for an investment.

Homeowners borrow money as a way to get on the property ladder. Whereas for investors and businesses, it’s about trying to increase profits.

They borrow to increase the amount of money “working for them”, with the hope their investments or the future profitability of their businesses will rise and therefore increase returns.

As you can imagine, leveraging comes with a few warning signs.

Companies, investors and fund managers will only adopt this approach if they believe the potential profits from an investment opportunity outweigh the interest that’s payable on the debt.

If the investment performs well, they could benefit from achieving higher returns that wouldn’t be possible without borrowing. It seems like the smart thing to do, right?

However, the stock market is unpredictable and new business ventures do not always pay off. Leveraging opens the door to bigger losses which could spell disaster if things go wrong.

What is leverage ratio?

Leverage ratio refers to the amount of debt compared to equity (things like land or buildings). They’re used to check a company’s ability to finance and pay off their debts.

There are lots of different types of ratios, but the most common one is probably debt-to-capital ratio. It’s calculated by taking the company’s total debt and dividing it by their total equity.

For example, Company ABC plc has £10,000,000 total debt and £20,000,000 total equity, which means their debt-to-capital leverage ratio is 0.5 (10,000,000/20,000,000=0.5).

Companies with high debt-to-equity ratios are typically taking on more risk to fund future growth. This should cause alarm bells to ring for investors as it’s a high-risk approach and these companies are more likely to go bust.

Debt might not seem like the end of the world, and it’s not, providing it’s kept at bay. But similar to interest rates on a mortgage, or credit card, the repayments can soon stack up if interest rates begin to rise and debt can quickly spiral out of control.

Leveraged trading

Leveraging doesn’t always mean a trip to the bank. Developments in the investing space means it’s now possible for investors to juice up their gains, or magnify their losses, through investment products called leveraged ETFs.

They’re collectively known as Exchange Traded Products (ETPs). But lots of investors use the terms ETF and ETP interchangeably, so we’ll use ETFs for this example.

How do leveraged ETFs work?

Leveraged ETFs are collective investment funds where investors’ money is pooled together into one single investment. They’re set up to multiply the short-term performance of a particular stock market index or commodity, such as the FTSE 100 index, or gold. Similar to shares, they trade on a live exchange with a live market price.

Most leveraged ETFs use derivatives to track the underlying investment. This adds risk. Derivatives are essentially a contract between two parties and the price of the contract comes from any changes in the underlying asset value.

It’s important for investors to know that leveraged products are extremely complex. They’re incredibly high risk and designed for short-term day trading (holding them for less than one day). We firmly believe investing should be a tool to improve your financial health and wellbeing over the long term, so we think investors should avoid speculating with short term products such as leveraged ETFs.

Leveraged trading example

Let’s take a FTSE 100 2x daily leveraged ETF as an example. It aims to replicate two times the daily percentage change in the FTSE 100 index. If the index rises by 5%, the ETF should rise by 10% (excluding any charges). Likewise, if the index fell by 5%, the ETF should fall by 10%.

This is an example of a ‘long’ position where you’re hoping the investment increases in value. But it’s also possible to take a ‘short’ position by investing in inverse ETFs. This can mean investors profit when the price of something goes down in value.

Investing in leveraged ETFs can be costly. These costs eat into returns which could lead to underperformance. Here are some of the costs involved:

Leveraged trading costs

  • Management fees – the fee you pay for the ongoing management of a leveraged ETF which is taken from the value invested. This is detailed on the factsheet or Key Investor Information Document (KIID).
  • Rollover costs – leveraged ETFs continuously enter and exit derivative contracts as part of the daily rebalancing. This results in interest charges and transaction fees.
  • Dealing fees – the cost of buying and selling leveraged investments through an investment platform or stockbroker. Most providers charge a flat rate per trade. Costs can rack up quickly when day trading, especially on smaller amounts.
  • Contango – where the derivatives’ price is higher than the current spot price of the asset. This is common with commodities (things like metals or foods) when their price is expected to rise over time.