Leverage

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Leverage
/ˈlɛvərɪʤ/
1. (n.) Technical: Amplification of gains or losses by means of borrowed money.
2. (v.) Fashionable: To use.

As a buzzword

“Please leverage this template to facilitate our discussion”.

Not only does leverage not mean “use”; it isn’t even a verb. It’s a noun: it describes the effect of using a lever on a fulcrum. “Lever” is also a noun, though you could at least use that as a verb. But you would sound stupid:

“Please lever this template to facilitate our discussion”.

As a technical financial term

“Leverage” – or “gearing” – came into the lexicon courtesy of the bankers. It properly describes the effect of borrowing money to invest: If you have ten pounds and you invest it, you get ten pounds’ worth of return. If you borrow ninety, add it to your ten and invest the lot you get one hundred pounds’ worth of return, minus your borrowing costs of the ninety. (Buzzword) bingo: you’ve created “ten times leverage” (note: still a noun) on your original investment. The more the market goes up, once it has passed your borrowing costs, the more leverage makes you look like a hero. But when it goes down — or just performs worse than your borrowing cost, it takes your shirt with it.

In financial analysis, the effect of leverage is assigned the Greek character vega. This is to distinguish it from “beta” — the market’s performance as a whole — and “alpha” — an individual portfolio’s performance, without taking account of the effects of leverage, measured against the market beta.

Positive “alpha” is extremely hard — some would say impossible, over an extended period — to generate. It requires the skill of a Meriwether, Scholes, Fuld, Skilling, Huang, Soros or Buffett. Vega, on the other hand, is really easy to generate, as long as you have someone credulous to borrow from.

From a distance it is easy — and, when the portfolio is doing well, tempting — to confuse alpha and vega, and many hedge fund managers do. There is a survivor bias problem here of course, because hedge fund managers do not often get the opportunity to talk about their negative alpha performance, because by the time it happens, the fund has imploded taking the hedge fund manager, its shirt and all its credibility with it.

It was leverage — not anything more difficult to understand than that — that caused the implosion of LTCM, the global financial crisis, and the Archegos affair.

Quite how such an ugly metaphor shape-shifted into an all-purpose business verb is anyone’s guess, but it is time it was sent back where it came from. With leverage.

One times leverage?

Leverage means the “amplification of an original force”. It doesn’t mean “borrowing” (any more than it means “use” or “fill out”), although people frequently misuse it that way. As a result, it is a metaphor that doesn’t bear close examination. A lever that produces “no leverage” would stop at its fulcrum. It wouldn’t lift anything. It would be worse than not using a lever at all.

To — er — leverage the metaphor, let’s say picking up a brick, without using a lever, takes one unit of force. Now, apply a lever which generates “one times” leverage: for every unit of force you push down on the lever, you get one unit of force up on the other side of the fulcrum. The force you apply is still just your own investment. You haven’t borrowed anything. You’ve just used a lever to do what you could have done without one. Get your kicks —

But if you lengthen (by borrowing) your side of the lever so that the single unit of force you contribute generates ten units of force on the other side of the fulcrum - now you’re “ten times levered”. To achieve this you need, as well as your original £10 investment, another £90.

See also

• Vega
• Leveraged alpha
• Long-Term Capital Management