Leverage Is Used to Juice Returns — But Research Shows It Undercuts Performance Instead

Thinking about adding more leverage to your portfolio? It may not be worth it, according to new research.  

An academic paper published in May shows that both institutions and individuals that take on leveraged investment positions tend to underperform, despite the added risk. 

The research comes at an interesting time: the recent blow-up of Bill Hwang’s heavily leveraged family office Archegos Capital has regulators scrutinizing the investment strategy — and what happens to it when a margin call takes place.

“There are many examples of institutions that became financially distressed due to huge losses caused by high leverage,” the paper stated. “These findings, overall, show that high leverage does not lead to high returns for investors, but reduces returns: investors pay for leverage.”

The researchers obtained a dataset that spans from January 2, 2014 to December 30, 2016 through an anonymous Chinese brokerage firm. The data includes 39.4 million futures trading records from 10,822 investors, of which 315 were institutions. The paper 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 magnitude is large,” the paper stated. To put those numbers into perspective, the researchers annualized the decrease: if similar leveraged applied each day, accumulated underperformance for gross returns would be 8 percent, while for net returns, it would be 13 percent per additional unit of leverage.  

According to the research, one possible reason for the performance reduction is that forced liquidations — or margin calls — only occur when investors lose a large amount of money.  

“The higher is the leverage, the higher is the probability of being mandatorily liquidated,” the researchers wrote. In turn, investors realize losses and they lose the opportunity to benefit from price rebounds, if they ever occur.  

The paper showed that on average, daily return (both gross and net) is lower by over 26 percent when these so-called forced liquidations occur.  

Another reason for the performance reduction has to do with higher trading costs. The research shows this through the decrease in net returns, which were higher than their gross return peers. “Large leverage enlarges trading positions, and hence should increase trading costs compared with those without leverage,” the paper stated.  

“Overall, leverage is a double-edged sword,” according to the researchers. “For the majority of investors, leverage reduces trading performance, although it makes investment returns more volatile.”