The pros and cons of leveraged investing

January 8 2008 by Ellen Roseman

Last Sunday, I wrote a column launching Money 911. Why that name? I think there’s an emergency for those who want independent advice, free of conflicts, from their financial advisers.

I talked about a man in his late 60s who got talked into mortgaging half his home’s value to buy investments. After a year, he was losing ground and was looking for help on whether to stick with the leveraging plan. He figured that his financial adviser, who worked for the bank that gave him the line of credit secured to his home, would not offer an impartial second opinion.

Leveraged investing is popular with many commission-paid advisers. I’ve met some who insist it’s right for every client — even those with new homes and young families. They’re zealots about how essential it is to boost your retirement income by borrowing to invest. But they don’t always talk about how lucrative it is for them.

In response to that column, I got two very intelligent and well-reasoned responses from industry insiders. I’ve posted them in the comments section and I’d like to hear responses from others.

7 comments

  1. Four Pillars

    Jan 9 2008

    I think that leveraged investing is not something that should be “sold” to a client. When done in moderation and using conservative investments, it’s not necessarily all that risky but most investors just don’t understand how it works well enough to know what they are getting into.

    Mike

  2. WhereDoesAllMyMoneyGo.com

    Jan 10 2008

    There are alternative ways to get leverage exposure as well, it should be pointed out.

    The Horizons Beta Pro Bull Funds offer 2x exposure to various indices. For example, HXU tracks the TSX and generally will give you 200% exposure (although not always precisely). This allows you to magnify your gains without having to borrow directly.

    Call options can be used as well. You can buy a call option on a stock and your loss is limited to what you paid for the option if the stock does not hit the strike price. If the stock goes through the strike price, it is possible to earn double and triple digit returns in the span of months (with great returns come GREAT RISK).

    (These two types of leverage are not an endorsement of the products, but rather things one should look into. I’ll leave it up to the readers to educate themselves.)

    Both are methods that allow for exposure to magnified performance without having to borrow money directly. BUT: Don’t forget that both of these methods are still VERY RISKY and YOU CAN VERY EASILY LOSE A LOT OF MONEY.

    If this is the first time you have heard of either of these strategies – then I would suggest that more research is required.

    Options: visit the MSE (Montreal Exchange). They have a great guide on options, available as a pdf.

    2x exposure ETF’s: Horizons Beta Pro, Powershares, Van Eck vector ETF’s, etc. A good place to look up ETF’s is http://www.indexuniverse.com – they have many articles and research, pro’s and con’s.

  3. Brian Poncelet, CFP

    Jan 20 2008

    Hello Ellen, Ted has made some excellent points and I would like to add a few more.

    The person who is leveraging should be at a high tax bracket, say 40% plus.

    Also, when an adviser puts in an order for a loan, the compliance department looks over the loan and reviews it to make sure it makes sense to the client. Loans and investments, in my view, should not be done under one roof. But if they are, the loan must be very competitive and the in-house funds should be very excellent. This may be hard to prove at a later date (the in-house funds).

    If it is a first loan, for the client there is no reason not to start small and go bigger over time. Sometimes clients think they can handle markets up and downs, but they really can’t.

    regards,

    Brian

  4. Marc

    Aug 4 2011

    I should preface my comments by saying I am not a big fan of leverage.

    I am a financial advisor with 5 designations and although the simple idea of leveraging is using someone else’s money to make money sounds very good in theory, in reality I have really seen it be successful.
    While I agree that anyone undertaken leverage should understand all the risk, should be able to take on additional risks, want to grow their net worth, etc… My only question…

    When I do a retirement plan for a client, never has it come out that the client is not able to achieve their goals without the need for leverage. Most clients I deal with are younger professionals/business owners so perhaps at a older age the answers are different?

    My belief is if you have funded your retirement plan fully (your goal); why take on the additional risk of leverage? If the goal is to increase wealth for the next generation… it is very tough to outperform a life insurance policy on the internal rate of return of the death benefit. We have done cases for clients with a net (after tax) return in excess of 10% was achieved even if they outlived their life expectancy. If we agree the rate of return on a leverage investment needs to be 3.65%-9.75% just to break even that means to outperform the life insurance (beyond life expectancy) you need to earn 13.65% to 19.75%.

    As a financial advisor (and a reasonable human being) I am not able to tell me client this is a possibility. There is allot of uses for life insurance in planning; they can generate very attractive returns for clients without the additional need of taking on risk. Yes, I agree life insurance is not available to all clients (due to underwriting) but to ignore this option in the right situation is doing our clients an injustice.

    My view on leveraging and whether I would ever introduce this to a client… I can’t imagine a situation whereby it makes allot of sense. My clients would need to come to me with the idea and sell me that it is right for them. Now a leverage investment with a term loan supporting it, that makes sense to me. The client is essentially getting the money in early as opposed to making regular contributions, but to take a line of credit and just pay interest seems odd and a recipe for disaster especially when the break even rate of return is almost 10%.

    The whole RRIF/RRSP meltdown is such a bad idea in my view. Taking the investment out of your RRSP/RRIF slowly just enough to offset the lending costs, just does not make sense. 10 yrs down the road you have depleted (likely) some of your RRSP/RRIF and if you have not outperformed your break even point, you still have the loan, but not enough asset (RRSP/RRIF) to be able to fully pay it. The question is the same, why are you doing the meltdown… likely because the money is not needed and you want to move it to a less taxable investment… is there a better option than life insurance in the assets are truly not needed?

    Because my goal is to deal with limited clients but for many generations, we are not big fans of leverage because we believe it is a recipe for disaster both for the client and for us, as when the client is unhappy we likely lose them. Sure I could make a nice big commission on a leverage deal, but down the road I likely have some unhappy clients and that goes against rule #1… keep clients happy.