Leverage

'Leverage' is a US term that is also known as 'gearing'. Both express the extent to which any transaction is financed by debt from lenders as opposed to capital provided by the investor.

Updated February 2019

Leverage means the use of debt to fund an investment, which has the potential to enhance returns, but also to amplify losses. Imagine two funds have investments of £100m. The first is entirely equity-funded (to the tune of £100m), and the second is financed with 50% debt and 50% equity. The following year the assets in the funds double in value to £200m.

The first fund's return on equity is an impressive 100% if it shut down now, it could return its investors' original £100m, plus another £100m. However, while the second fund would need to pay back £50m of debt to the lender, the remaining £150m would be returned to investors, meaning they would have made an even more impressive profit of 200% on their original equity.

So here, leverage has worked in the investors' favour. However, if the funds made a loss instead, it would have the opposite effect. Let's say the value of the assets halve, to £50m. The investors in the first fund would get back the remaining £50m, suffering a loss of 50%. But the second fund must use all its remaining assets to repay the £50m it borrowed, so investors would get nothing a loss of 100%.

A similar principle is at work when investing in a house with a mortgage (which is why buy-to-let became so popular in the late 1990s) and it's also the way that spread betting works, only with far more leverage and a much lower initial deposit.

Leverage is also referred to as "gearing". Many investors use "leverage" to refer to the use of debt, and "gearing" to refer to one of several measures of how much debt is being used relative to the amount of equity. Our first fund is "ungeared". The second begins with a debt-to-equity ratio of 100% (£50m debt/ £50m equity); a debt ratio of 50% (£50m debt/(£50m debt + $50m equity)); or an equity ratio of 50% (£50m in equity/ (£50m debt + £50m equity)). All three ratios are common measures of gearing.

See also: Gearing

Watch Tim Bennett's video tutorial: Three ways leverage can boost your returns.

Recommended

The end of the bond bull market, and how to invest for it
Investment strategy

The end of the bond bull market, and how to invest for it

The great bond bull market looks to be over, and you probably don’t want to be holding government bonds, says Merryn Somerset Webb. Here’s what you sh…
21 Sep 2021
Carbon emissions trading: how to profit from the price of pollution
Funds

Carbon emissions trading: how to profit from the price of pollution

Carbon-emission allowances are still an esoteric market, but one that looks set to grow. This new fund could help you cash in.
21 Sep 2021
Fund managers are good at buying shares – but terrible at selling them
Investment strategy

Fund managers are good at buying shares – but terrible at selling them

Buying shares can be tricky. But selling them can be even trickier – even the professionals don’t get it right. John Stepek investigates why, and expl…
13 Sep 2021
Pershing Square: a deeply undervalued investment trust to buy now
Investment trusts

Pershing Square: a deeply undervalued investment trust to buy now

Pershing Square Holdings has a strong record, but trades at a discount of almost 30%. It could be the ideal investment for uncertain market conditions…
13 Sep 2021

Most Popular

The times may be changing, but don’t change how you invest
Small cap stocks

The times may be changing, but don’t change how you invest

We are living in strange times. But the basics of investing remain the same: buy fairly-priced stocks that can provide an income. And there are few be…
13 Sep 2021
Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
How to stop recurring subscriptions becoming a drain on your money
Personal finance

How to stop recurring subscriptions becoming a drain on your money

Tracking and pruning subscriptions isn’t as easy as it sounds. Here's how to take charge.
14 Sep 2021