The Biggest Leverage Risk Isn’t in the Market

But with enough leverage, investors can go bust. It’s easier than ever to do when any investor with a phone can access exchange-traded funds offering more than 100% leverage. The high likelihood of financial self-harm has motivated the Securities and Exchange Commission to push back on new ultra-levered ETFs. It’s a warning investors should heed.

There’s a difference, though, between individual and systemic risk related to leverage. For those worried about the amount of leverage in the market overall, the obvious question is how much is out there. Unfortunately, that’s surprisingly hard to answer. There isn’t one number to point to, nor does the available data necessarily provide a full picture. (Note to financial regulators: That would be very useful and prudent information to have!)

Still, while there are always individuals and funds with too much leverage, the available aggregate numbers don’t give the impression of a market awash in it.

One data set comes from the Financial Industry Regulatory Authority, which tracks the amounts investors borrow from brokers in their margin accounts. At the end of November, Finra reported total debit balances of $1.2 trillion in accounts with its member brokers. Meanwhile, the value of the US stock market net of that margin is $68.4 trillion, resulting in leverage of 1.8% as a ratio of margin-to-net market value. That number has hugged a tight range between 1.2% and 2.6% back to 1997. The current reading is about average.

The Federal Reserve compiles a similar data set, which may overlap somewhat with Finra. Using the same calculation, the Fed data shows a persistent decline in leverage over the past three decades, with some variability along the way, to 0.8% at the end of the second quarter from 1.6% in the early 1990s. That jibes with the longer-term decline of leverage in the Finra data. Even when combining the two, which may double count to some extent, the leverage is only 2.6%.

A bigger source of leverage is hedge funds. The Office of Financial Research tracks hedge fund borrowing from US and foreign banks and non-bank lenders back to 2013. In absolute dollars, the total number has swelled significantly. But as a percentage of net market value, it amounts to leverage of 10.9%, up from 7% a decade ago. That’s higher than the leverage in brokerage accounts but still very modest.

Retail funds also deploy leverage, mostly through levered, inverse and derivatives-based ETFs (the number of similar mutual funds is small and declining). They get a lot of attention because they pack ludicrous amounts of leverage — they’re essentially casinos wrapped in a polished prospectus. Their numbers are also growing fast: They account for 30% of the roughly 950 ETFs launched this year through October, according to Morningstar Inc. But their collective $300 billion in assets represents just 2.3% of the money invested across all ETFs, and their percentage of flows isn’t much higher.

All of that together amounts to leverage of no more than 16%, hardly enough to worry about.

Granted, that number is based on the stock market’s current value, which some argue is inflated. But it still wouldn’t be terribly high if the market were closer to its long-term average valuation. The Bloomberg US Aggregate Equity Index trades at 26 times expected earnings over the next 12 months. Holding earnings constant, the stock market would have to decline by 25% for the index to reach its long-term average multiple of 19.5 since 1993. A dip of that magnitude implies a 33% rise in leverage to closer to 21%, assuming none of the debt is called.

Investors can also take comfort from the fact that companies themselves are less leveraged than they used to be. Debt-to-equity for the Bloomberg Index is about 110%, down considerably from an average of closer to 180% from the 1990s through the financial crisis. That may provide a higher floor for stock prices than in previous downturns.

Even though overall leverage in the market appears to be modest, investors can still get into trouble with readily available margin from brokers and in highly levered funds. For now, the biggest risk around leverage isn’t in the market but in investors’ own portfolios.

A message from Advisor Perspectives and VettaFi: Discover something new! Click here to register for our upcoming webcasts.

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by Nir Kaissar