Real estate investment is typically leveraged. Investors take 70-80% bank borrowing against 30-20% equity or own funds. Leverage improves returns if asset price appreciates.
This article explains the benefits and the risks of a leveraged portfolio.
It then shows why leverage may not be optimal for the passive core portfolio. Discerning investors could, however, employ some leverage through active futures position as part of their satellite portfolio.
There are obvious advantages of using leverage. Suppose an investor borrows Rs one lakh at 8% interest and earns 10% return on a total investment of Rs 1.5 lakh.
The return after paying interest amounts to 14% (Rs 7,000 divided by Rs 50,000). This compares well with just 10% return the investor would have earned if she had invested only her capital of Rs 50,000.
Now, suppose the investor had Rs 1.5 lakh of her own money but chose to invest only Rs 50,000 while borrowing the rest for the above investment. She now has the balance money available for further investments. Leverage, thus, helps investors `extend` their investments to other asset classes as well.
But beware. There is a flip side to leverage. It magnifies the effects of negative returns-compounding.
In the above example, suppose the investment of Rs 1.5 lakh declines 10%. After paying for interest on borrowing, the investor would suffer negative returns of 46% on the investment of Rs 50,000!
The question then is: How useful is leverage in equity portfolio?
We define leveraged equity as one where investor uses futures to take the required exposure. An investor who wants to buy, say, Nifty Index Fund can instead buy Nifty Futures, as it requires only a fraction of the money needed to take the exposure.
There are several problems with such a leveraged investment. One, there is a mismatch in time horizon if the investor uses futures to replicate beta exposure in the equity core. This is because equity core is set-up for specific investment horizon, while futures are short-term contracts. The investor has to religiously roll-over the contract every month to continue the exposure till the required investment horizon. This exposes the portfolio to roll-over risk - the risk that the next month futures contract price will be higher than the current month. And two, there is a difference between real estate leverage and equity leverage. Real estate typically earns rental income while the only source of return from futures contract is capital appreciation. Such sole dependence on market price for returns magnifies the negative returns - compounding effect on leveraged equity, as illustrated above. This factor assumes importance because investors typically tend to suffer from loss-aversion effect. That is, when faced with price declines, investors tend to hold on to their loss-making position because of their unwillingness to realise losses. Such behaviour could prevent the portfolio from achieving its investment objectives.
Conclusion
Equity leverage is not always harmful. Discerning investors could allocate a proportion of their total assets (not more than 5%) to active futures position. Such exposure should form part of the active satellite portfolio, not the passive core. It is important to control risk, yet generate higher returns from such active trading.
Some investors prefer to borrow money to leverage their risk-parity portfolio (refer this column dated October 3, 2010). We do not encourage such leverage because of its downside effects. Real estate leverage may be good, as long as the rental income pays for the mortgage. This is not the case for other assets, especially leveraged equity using futures. Leveraged portfolio is, hence, best left for institutional investors.
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