June 1999

When Leveraging Equity
Funds Makes Sense

© Talbot Stevens

Last month's Strategy Sheet introduced several leverage related myths that prevent people from exploring the pros and cons of leveraging, or borrowing to invest.

An additional myth, even advocated by most tax professionals and accountants, is that for leverage to make sense, the returns must be higher than the interest expense.

Borrowing to invest would only make sense when returns exceeded the cost of borrowing if you could only invest in interest-bearing investments that are 100% taxable each year. But this conclusion is not true for equity investments which are mostly capital gains that are taxed less, and later.

The table compares the merits of leveraging equity investments for a typical 45-year old baby boomer that invests $4,500 a year for 20 years, and is in the 50% tax bracket. Assuming a 9% interest expense, leveraging $100,000 requires annual interest payments of $9,000, or $4,500 a year after deducting the interest charges. After 20 years, the investment loan is paid off completely. To be realistic, a portion of the equity returns (30%) is distributed and taxable annually.

With average equity returns of 0%, not using leverage would produce $90,000 after 20 years — the same amount as invested. With leverage, there is nothing gained and all of the interest payments are down the drain.

Notice that in this case the breakeven point for leverage is an equity return of about 3.9%, less than half the cost of borrowing.

When equity returns average only 5.3%, the unleveraged and leveraged strategies produce the same net amount of $147,000 after 20 years. This dispels the myth and shows that as long as returns are at least 5.3% or less than two-thirds of the 9% interest expense, leveraging equity funds will net more than not borrowing to invest.

Leveraged vs. Unleveraged Equities After 20 Years (000s)
Return No Lev. Lev. % Diff.
0% 90 0 -100%
3.9% 128 90 -29%
5.3% 147 147 0%
9% 213 375 76%
12% 291 696 139%
15% 402 1,214 202%

When returns match the 9% interest expense, leverage increases the retirement fund by about 76% after 20 years.

With 12% equity returns, which is about the historical long-term average for global equity funds, the difference is significant.

In this case, leveraging equity funds averaging 12% returns produces $696,000 versus $291,000 without borrowing to invest, more than doubling the baby boomer's retirement fund. Properly implemented, the tool of leverage could add more than an extra $400,000 20 years later — per $100,000 leveraged.

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