How to leverage on investments?
So far we have discussed that owning single name stocks is a no. It is better to own a diversified basket of stocks, like an S&P index. Ok, you heard this pitch before from others, just buy a diversified basket of stocks and hold till retirement, adjust the weights against bonds, based on your age, with a tilt towards a more conservative portfolio as you approach retirement.
Let's up the ante. As my username defines, we want to leverage this up. How?
- Leveraged ETFs. A leveraged exchange-traded fund (ETF) is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. These ETFs are available on the US exchange. There are a few disadvantages of this product and you can find out more in this link below. What many investors don’t recognize is that leveraged ETFs are rebalanced daily. Since leverage needs to be reset on a daily basis, volatility is your greatest enemy. This probably sounds strange to some traders. In most cases, volatility is a trader’s friend. But that's certainly not the case with leveraged ETFs. In fact, volatility will crush you. That’s because the compounding effects of daily returns will actually throw off the math, and can do so in a very drastic way.
You can pledge your shares or ETFs as collateral with a bank or financial institution to get a loan to leverage up on more stocks. The problem with this is firstly, depending on the financial institution, the maximum leverage is normally 1 to 1, so using 200k to buy 400k of stocks. Secondly, these are normally catered to high net worth individuals. If you want to borrow 10k to buy 20k of stocks, most financial institutions will not bother entertaining you.
Futures trading. This is my personal favorite and let me tell you why. Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. By buying an S&P future, you are exposed to the movement in the S&P. Your margin depending on your provider can be as low as 5%. This means you can own 20 times exposure of the S&P index. No ETF or bank lending will allow that exposure. Compared to ETFs however, you need to keep rolling the future every quarter.
Of course, with higher leverage, this means higher risk. I will share more about risk management in my next post.
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