For those who are unclear, leverage is simply borrowing money from your broker to invest in the stock markets.
People do not typically assume leverage to be defensive in nature. The idea of borrowing money to invest is by nature, assumed to be an aggressive action.
This is true. Leverage is and remains a double-edged sword.
DBS Bank has done a pretty good job of illustrating the benefits of having extra capital.
But you must also remember that leverage works both ways: you can both win and lose.
And win or lose, you have to return what you owe to the broker.
So how is a Leveraged Portfolio “defensive”?
#1 Leverage Helps You Increase Your Diversification
For investors with smaller capital sums, it may be frustrating to diversify their investment holdings.
Suppose a rookie DIY yield investor has a few concentrated positions in Singapore blue-chip stocks (such as DBS or ViCom).
By borrowing money from a broker, he can increase the number of stocks that he owns without putting up more cash.
While it can be argued that the counters this investor would select may still have the effect of magnifying the risks he takes, if this investor were to load up with a more stable counter like the DBS 4.7% Preference shares, he may be able to enjoy significantly boosted returns with a smaller corresponding increase in volatility.
By adding a preference share to his portfolio of stocks, his collateral can also retain it’s value better against gyrations in the stock markets, lowering his overall market risk.
The key is, therefore, to use the added cash from your leverage account, to select higher-quality stocks and to diversify appropriately.
#2 Leverage May Be a Convenient Means of Dealing With Fresh Rights Issues and Corporate Actions.
Rights issues are the bane of retail REIT investors.
A rights issues is often accompanied by a temporary drop in share price as investors decide to punish the REIT management, there is also the question as to how to raise the cash needed to participate in the rights issue.
In the case of Kep-KBS US REIT, the managers decided a rights issue last year in October. Prices dipped when the announcement was made, but folks who participated in the exercise would see a pretty hefty gain today as evidenced in the chart below :
Having a margined portfolio effectively means a credit line to participate in rights issues.
You have the option of exercising your rights to buy more REITs without putting up more capital into your account.
This is convenient for investors who do not have cash sitting around in their bank accounts. You will just need to tolerate a higher margin account ratio over the next few months.
Sometimes an investor, as in the case of Lep-KBS US REITs, would even be able to sell the rights away with a modest profit after the stock has recovered from the fallout from the rights issue.
Leverage thus allows you to profit from nasty situations if you know what you are doing.
#3 Leverage can Grant You More Exposure to Investments with a Higher Quality
A lot of defensive high-yield REIT investors find themselves tolerating REITs with major concerns as it is the only way to earn higher yields.
Lippo Mapletree Indonesian Retail Trust provides yields above 8% because of concerns over its sponsor and political risks associated with Indonesia. Soildbuild REIT, another REIT that produces high yields, is owed rent by one of their key tenants NK Ingredients.
An investor that is fixated with higher yields will have a portfolio that is comprised of REITs such as those mentioned earlier and may need to monitor their investments closely.
Leverage allows this same investor to take up a position on a well-managed counter without sacrificing high yields.
One possibility is Frasers Logistics and Industrial Trusts, a solidly managed counter, that yields about 5.8% to a non-leveraged investor. Leveraging with an equity multiplier of 2 and a financing fee of 3.5% can produce a yield of (5.8%x2-3.5%) or 8.1%.
A REIT that will not ordinarily find a place in a high-yield REIT portfolio is now a welcome addition in a margin account.
Various academic theories have proposed that leveraging a safer portfolio produces better returns than an unleveraged portfolio consisting of risky stocks.
In spite of these defensive qualities enjoyed by leveraged investors.
Leverage remains a dangerous undertaking that should only be attempted by investors who are very aware of the risk that they are undertaking with their portfolios. Even for the expert investor, the occasional margin call in a bad market may be unavoidable.
A key component to successful leveraged investing involves engineering a portfolio that has, empirically, a higher return and lower risk than a conventional strategy such as investing in the STI ETF.
Leverage is risky, but with the right applications and the right moves on the chessboard, is far less risky than previously assumed.
I have provided some amount of ideas as to how to handle such moves and applications above. Namely,
- Take advantage of corporate actions when possible, and,
- Select good counters
Yet I will not blame some of you for having yet more questions.
- How do we rigorously engineer a portfolio that allows us to take maximum benefit of leverage with as minimal a risk as possible?
- What do we do when markets go south? How do we handle margin call possibilities?
- How has the trade war affected us thus far? (markets dropped, our portfolios remain stable)
These are all questions I answer in my Early Retirement Introductory Masterclass. You can register for a seat here.
If not, I hope the article has been informative for you readers in deciding how to best approach the double-edged sword that is leverage.
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