Dear Expert:
Recently a financial planner suggested I leverage to buy mutual funds. Please give me some feedback on this as a general investing strategy.
Expert answer:
Leverage, or borrowing money for the purpose of investing, is seen by some investors as a potentially lucrative means of amplifying a return on an investment. In theory, the profit gleaned from the additional investment capital raised through a loan will more than cover the cost of that loan.
But leveraging is not the magical solution for expanding one's investment portfolio that many may make it out to be. You should never forget that your liability to the lending institution is very real and fixed in value, and the assets in the mutual funds you buy with this borrowed money have no guarantee.
You need to assess your ability to handle the risk of a leveraged portfolio should the markets turn downward. Say you have $10,000 to invest and you are going to borrow $30,000 to add to this. If your funds' value dropped by 10%, or $4,000, that would be the equivalent of losing a whopping 40% on your original investment.
Above all, make sure you have a good understanding of what sort of returns you need from your investment portfolio in order to make the process profitable. Don't forget to consider that interest rates may rise and increase the cost of your investment loan -- and also require that you make more on your portfolio just to break even.
You also need to understand how your advisor will be paid. In the above example, investing only $10,000 could reward your advisor with a $500 commission if the fund was sold on a front-load basis, reducing your initial investment to $9,500; on a $40,000 purchase, the commission could leave you with a $38,000 initial purchase. This is yet another cost that has to be compensated by returns before you actually start making money on your investment.
Naturally, most advisors prefer to sell funds on a deferred sales charge (DSC) basis, so you may not in fact "see" the payment that your advisor receives. Nevertheless, the payment is there and you need to understand that should you suddenly need to redeem your investments to pay out the leverage, it could cost you as much as 6% to exit your funds.
Unwinding our example above, the $40,000 has suddenly declined by 10%. You now have $36,000, so you choose to sell out. On your DSC funds, the exit commission is 6% of $40,000 (the original amount of investment), a cost of $2,400. Your net proceeds are $33,600 and you repay the $30,000 leverage loan, leaving you with only $3,600 or 36% of your the original $10,000. In other words, a mere 10% market decline on the leveraged portfolio has turned in to a capital loss of 64% on the original capital you had to invest.
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No statement in this article should be construed as a recommendation to buy or sell securities or to provide investment advice or individual financial planning. Morningstar Canada does not provide specific portfolio advice and recommends the use of a qualified financial planner when appropriate.
