Monday, September 04, 2006

The use of leverage 0 comments

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Financial leverage is the use of debt to magnify the rate of return on equity. In business, it involves bank borrowing which is used together with shareholder's equity (including retained earnings) to jazz up growth. For the small investor, it typically involves buying on margin, such that he only contributes a certain proportion of the total value of shares purchased through his own pocket, say 50%; the remainder is financed through broker margin, essentially a loan from the broker.

Margin financing is tremendously attractive for those who wish to ramp up their trading capital quickly and magnify potential earnings; clearly there is no such thing as a free lunch and besides the interest payable on such margin loans the trader also knows that he is also liable to magnified losses. Fair deal and just a matter of risk and return? I don't think so. I have never done margin buying and will not do so in the future.

The main reason is that margin buying, by virtue of the way the deal is structured, forces the hand of the retail investor/trader and requires him to make short-term calls on the market. He could be right about the stock in the medium/long term but yet he could lose money through buying the shares on margin. For the common initial margin percentage of 150% (meaning 2/3 of shares financed by margin) a 7% drop in share price brings him to the maintenance margin of 140% where he is subject to margin call; he has to sell if he does not have additional capital to top up. Even if he finances through a margin percentage of 200% (ie. only 1/2 of shares financed by margin), margin call is triggered in a 30% drop for the share price. Such price moves are possible in a market undergoing a correction (such as that in mid-May) and the weak holders, first the contra players and then the margin holders, are whipsawed. Either they have to sell off the margined shares, or they have to liquidate other stocks in their holdings to obtain the cash for topping up their margin accounts. Now the market is back where it was pre-correction. For those who buy futures, the inherent leverage is even higher, about 20 times, meaning the margin for error in judgment is even thinner.

The long and short of it is that there is limited room for error in the short-term for margin players. It is not just that returns and losses are magnified, but also that investment/trading horizon has to be considerably shortened. Not being right in the short-term will lead to margin calls, which is basically a system implemented by the brokers to protect themselves. Yet the short-term is considerably more of a random-walk process than the medium/long term; there is no real competitive advantage for the analyst who tries to find companies with good fundamentals and value, given that more often such value manifests in prices over a longer period. In other words, buying on margin erodes the competitive advantage of the fundamental analyst. On the other hand, good traders may find buying on margin a useful way to make money if they feel they have some competitive advantage in the short-term, say a superior ability to gauge market technicals or better access to information (assuming they don't believe in an efficient market); margin calls may be irrelevant anyway if their stop losses are set above the prices at which margin calls might be made.

It is worth noting that the most sophisticated of market players today, the hedge funds, use substantial leverage to magnify their returns, reflecting an inherent confidence in their mathematical models. The main motivation for using leverage is that it is difficult to obtain good returns for big money without substantial borrowing to magnify returns. The kinds of strategies that they often practise, which often involves a combination of long and short positions to cancel out each other, or various forms of arbitrage strategies, offer highly liquid investment channels for the huge sums managed but typically involve small profit margins which they therefore magnify through borrowing to boost return on equity. This has led to occasional disasters such as Long-Term Capital Management. The small investor will never practise these hedge fund strategies, has no pressure to perform for the short-term for demanding clients, and therefore has no reason to tack on the substantial risks and compromises on his investing horizon that margin financing brings.




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