Using leverage to realize higher returns is a risky practice. History is full of examples where the use of what is a form of debt caused significant financial harm.

The 2007–2009 financial crisis showed just how much mass damage the improper use of leverage can have. Many home buyers inflicted harm on themselves. During the mid-part of the last decade, there were a large number of people who took out zero-down-payment mortgages or otherwise borrowed far too much on houses that were speculatively priced. At the same time, purchasers of mortgage-backed bonds willingly ignored analyzing the loans comprising those securities in order to get a higher yield. We all know what the aftermath was.

We can go further back and find history rhyming, if not repeating. WorldCom’s CEO, Bernie Ebbers, used his company’s stock as collateral to borrow money. It didn’t end well, as some of you may remember. Traders found themselves caught flat-footed with margin calls during the 1987 crash. Even the 1929 stock market crash was preceded by extremely low margin requirements for novice investors and other speculators.

Wall Street continues to be more than happy to let you speculate with leverage. No worries about you losing your shirt; there will surely be another person ready to take your place.

Not all leverage is inherently bad. Responsible borrowing allows people to become homeowners. It also helps existing homeowners by boosting home prices. Just imagine what prices would be if buyers had to come up with the full purchase amount instead of just a down payment. They would be considerably lower, without a doubt.

In the world of investing, leverage can boost returns. In his book “Investing at Level3,” our own chairman, Jim Cloonan, gives an example of how using 25% margin can add two percentage points of return to a portfolio already following a strategy historically shown to realize 12% annualized returns. Adding leverage on the initial starting balance of $250,000 results in an additional $722,000 of wealth over an 18-year period ($2,644,000 versus $1,922,000).

As enticing as the numbers may look, Cloonan warns readers about the risk: “I hesitate to suggest most investors use margin in this way because only a few investors would be able to stay focused and adhere to a strategy in worst-case bear markets.” Put another way, margin is great until it turns and bites you.

I bring the issue of leverage up because anybody can open a brokerage account and start using leverage. For about the same amount of money as it costs to take a family of four to the movies these days (and in some instances, less), a person can buy a share of a leveraged exchange-traded fund (ETF) or exchange-traded note (ETN).

Leveraged ETFs seem pretty straightforward on the surface. Most are designed to return between one and three times the daily return of the underlying index in either direction. Ultra funds give you returns of 2% or 3% on days when their underlying index rises by 1%. Inverse funds give you returns of 1%, 2% or 3% on days when their underlying index falls by 1%.

The returns you actually realize by holding on to such funds for more than a short period of time are less than what their names would imply. More importantly, because they use leverage, when the market goes in the opposite direction of the ETF you are holding, you will lose money quickly.

To provide greater insight about leveraged ETFs, I asked William Trainor to write about them. Bill is a professor at East Tennessee State University and has published several papers on these funds in academic journals. Here, he does a great job of explaining not only how these funds work, but also how their returns evolve over time and how they might fit into a broader portfolio strategy for a disciplined, risk-adverse investor.

As you read the article, keep in mind one longstanding axiom attributed to John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII