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.