Thinking of adding more leverage to your portfolio? It may not be worth it, new research shows.
A academic document released in May shows that institutions and individuals who take leveraged investment positions tend to underperform, despite the added risk.
The research comes at an interesting time: The recent explosion in Bill Hwang’s highly leveraged family office Archegos Capital is forcing regulators to scrutinize investment strategy – and what happens to it when a margin call takes place.
“There are many examples of institutions that have found themselves in financial difficulty due to huge losses caused by high leverage,” the newspaper said. “These results, on the whole, show that high leverage does not lead to high returns for investors, but lowers returns: investors pay for leverage.”
The researchers obtained a dataset that spans January 2, 2014 through December 30, 2016 via an anonymous Chinese brokerage firm. The data includes 39.4 million futures transaction records from 10,822 investors, of which 315 were institutions. The article was published by University of California Professor Avanidhar Subrahmanyam, Tsinghua University Professor Ke Tang, Beihang University Associate Professor Jingyuan Wang, and Nanjing University Associate Professor Xuewei Yang.
Their results show that a one unit increase in leverage “implies” a decrease in an investor’s daily gross returns by 3.3 basis points and net returns by 5.35 basis points.
“The scale is great,” the newspaper said. To put these numbers into perspective, the researchers annualized the decline: if a similar leverage was applied each day, the cumulative underperformance for gross returns would be 8%, while for net returns it would be 13. % per additional unit of leverage.
According to research, one of the possible reasons for the reduction in performance is that forced liquidations – or margin calls – only occur when investors lose a large amount of money.
“The higher the leverage, the higher the likelihood of being forced to liquidate,” the researchers wrote. In turn, investors realize losses and lose the opportunity to profit from price rebounds, if they occur.
The paper showed that, on average, the daily return (gross and net) is more than 26% lower when these so-called forced sell-offs occur.
Another reason for the reduction in performance is related to the higher trading costs. Research shows this through declining net returns, which were higher than their gross return peers. “High leverage expands trading positions and therefore should increase trading costs compared to those without leverage,” the document said.
“Overall, leverage is a double-edged sword,” according to the researchers. “For the majority of investors, leverage reduces trading performance, even if it makes returns on investment more volatile.”