It’s the leverage, stupid! Why we trade with borrowed money & must we do it?

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I guess Bill Hwang, the former hedge fund manager who managed Archegos, would have made tonnes of money in his career using leverage correctly. To expect him to suddenly change style and behave like Warren Buffett is expecting every roadside robber to transform and become Valmiki.

He had a bad trade and, hence, blew up. If the trade has turned otherwise, he would have increased his billions and would have made it to the cover of a leading business magazine with a headline: ‘The resurrection of Bill Hwang’.

The blowup of a US hedge fund has resulted in the WhatsApp university offering many courses on what went wrong with Bill Hwang and Archegos. You will learn from so-called experts on why leverage is bad, how Archegos could have avoided the implosion and so on.

Let me try and explain in simple terms how leverage works in real life. For simplicity, I have used round numbers and one-year time frame. B is a smart investor, and he knows that shares of V will fly and rise by 30% in one year. He can either invest Rs 1,000 of his own money or borrow from a bank or an NBFC and invest.

If he invests using his own money, then at the end of one year, he will have Rs 1,300 worth of shares. So, he has earned Rs 300 on his investment of Rs 1,000, which is a 30% return on his investment.

In case he borrows Rs 1,000 to add to his own money, then end of one year, he will have Rs 2,600 worth of shares on the asset side, but he will also have to repay the Rs 1,000 debt that he had taken plus interest, which we assume is 10 per cent per annum. Hence, he is left with Rs 2,600 less Rs 1,000 debt less Rs 100 interest, which comes to Rs 1,500.

He has made a cool Rs 5,00 on his investment of Rs 1,000, which is 50% return on his investment. This is the economic reason why people borrow – to earn more money. This is even more pronounced with hedge fund managers, because their incentives and bonuses are linked to extra returns they make over the benchmark.

To beat the benchmark, one has to take extra risk and leverage. You can see from the above example, that debt taken by B is a fixed obligation. He has to pay at the end of one year with interest, which is Rs 1,500. The returns from his purchase of shares of V is uncertain – they can rise, they can fall or can remain the same. The problem starts when they do not rise as expected, thereby causing problems.

For example, if shares of V remain unchanged, then after end of one year, B has to repay Rs 1,100 and, hence, will be left with Rs 900 only. If he has invested only his own money, then at end of year, he will be left with his initial capital. For simplicity’s sake, let’s not get into opportunity cost of capital etc.

Any hedge fund typically uses leverage to improve returns. All prime brokers allow their hedge fund clients to leverage with a view to earning more brokerage and interest income. The debt one takes is against a collateral of an asset, which typically is the security one has bought. In the example above, B would have pledged shares of V to borrow. For the lender, he gets Rs 2,000 worth of V stock against a loan of Rs 1,000. The problem gets accentuated when the security, in our case shares of V, starts falling. In such a case, the borrower has to give additional collateral. If the borrower is over-leveraged, then he cannot give additional security, hence the lender is forced to liquidate the shares to recover his debt further adding to the borrower’s misery.

Therefore, the variables in the equation are how much debt you have taken. The commonly used measure is debt-to-equity ratio. Higher the number, higher the risk and higher the chances of a return too. If you are right, you will come out smelling of roses and the world will want to do more business with you. When it comes to interest cost, higher the cost, higher the risk. That is why low or falling interest rates increase risk appetite across all classes of investors.

The last variable being the returns made from the investment. This is unknown and uncontrollable by anyone, including the masters of the universe, aka hedge fund managers, private equity investors or anyone for that matter. The trick to remember is to ensure that your asset earns more than your interest cost, otherwise you are going down the tube fast.

Then, you have market participants, who add the momentum both ways. When there is a problem, other market players who are unaffected come to party. For example, the moment, the market became aware of the problems of Archegos, other players would have started selling Archegos portfolio short, knowing well that prime brokers will be selling to recover their dues.

This is normal. In fact, during the sub-prime crisis of 2008, it was rumored that a leading institutions betted against their own clients and made tons of money.

There are lessons to remember here:

  • Greed is universal: This is a universal truth and there is nothing any regulator or anybody can do. This is a basic human instinct and you cannot really regulate greed and fear.
  • Use leverage with caution: Investors, be it retail or institutional, need leverage, which is like a double-edged sword. It can hurt or reward you depending on the outcome. You are advised to use leverage carefully. Take only that much leverage that allows you to sleep well at night. Most of us are better off with zero leverage. Sophisticated investors use leverage and even they can make mistakes. Dalal Street is littered with tombstones of such smart but leveraged investors.
  • Markets have a convenient memory: People forgive past mistakes when they see an opportunity to make money. Here was an investor who paid fines for insider trading, and still all major banks were dying to do business with him. Goldman Sachs came last to the party because of objections raised by their compliance team, I assume. But the moment they saw the brokerage and interest earned by others, they would have thrown caution to the winds. Do not let this surprise you. If you remember your party going days, the person who comes last, drinks fastest – he has to catch up. Similarly, in every cycle, there are a set of companies, which change their name, swear corporate governance, and come back into investors’ radar. A leopard rarely changes its spots so do not waste time.
  • Warren Buffet is quoted but few walk the talk: Everyone and their children read books on value investing and position themselves as the next Buffet. But none has his psychological mindset or age advantage. Thanks to his age, he has enjoyed the maximum benefits of compounding whereas the clones want to get rich quick. To reduce the time factor, some increase their leverage and therein lies the rub.

As far as you are concerned, dear reader, understand your risk appetite and focus on asset allocation. Stick to the boring part of remaining disciplined and with time, you will eventually build your wealth.

(R Venkataraman is Chairman of . Views are his own)

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