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This article is from the A Guide to Closed-End Funds (CEFs).

Investing in Closed-End Funds: Leverage

A primary use of a margin account is to borrow money with the securities in the account as collateral, usually to invest. Buying on margin, when properly understood, may provide aggressive investors with a strong tool: leverage. To see how this works, consider an example: Investors A and B have $50,000 to invest. Investor A buys 5,000 shares of a $10 CEF. Investor B buys 10,000 shares of the same $10 CEF, but fully margined, that is, he puts up $50,000 and borrows $50,000 more from his broker (with the $50,000 worth of shares as collateral). Suppose, the CEF performs well, and in a reasonable period of time, doubles to $20, at which point both investors sell their shares. Investor A shows a profit of 5000 * $10 = $50,000 or 100%. Investor B, however, shows a profit of 10,000 * $10 = $100,000 or 200%. The reason is simple, with the same amount of money, investor B controlled a larger number of shares (hence, the term, leverage).

However, there is a downside to leverage as well: if the CEF drops to $5 instead of rising to $20, and both investors exit at this point, investor A shows a loss of 5000 * -$5 = -$25,000 or 50%, but investor B is wiped out: 10,000 * -$5 = -$50,000 or 100%. So leverage magnifies your losses as well as your returns.

There are additional factors to be considered: a) Since you borrow funds from your broker, you pay interest (though this is usually less than what a bank or credit card might charge). Interest was not considered in the above example. For an investor who is leveraged to show a profit the security must rise at least over the cost of borrowing. b) Usually brokers impose restrictions on stocks that can be margined (e.g., stocks under $5 are usually not marginable). c) If the market price drops below a certain threshold, the broker may require you to deposit additional money or liquidate a portion of your holdings. This is called a "maintenance call".

The negatives aside, margin can be a useful tool for aggressive investors, when the risks and rewards are well-understood. Timing is critical. Use leverage when the markets are depressed (significantly off their highs) and the discounts for CEFs are unusually wide. In this case, the downside risk is low: a) the market has to drop further (which it may), and b) the market price of the CEF has to drop further. We really can't predict markets (technical analysis not withstanding :-), so the second factor is more critical. If the discount is unusually wide, sometimes, even if the market continues to drop, the market price of the CEF may not: the discount may narrow to cushion the drop. In some unusual cases, the market price may actually go up, despite the drop in the market! See for example, the behavior of the Jakarta Growth Fund.

This risk has to be traded off against four benefits: power of the market going up (and hence the NAV going up), the shift of the discount back to its original typical discount, the leverage of the discount, and the leverage of buying with margin. A compelling case for leveraging CEFs: lower risk, higher rewards. Contrast this to leveraging stocks (where there is a risk of the company going bankrupt and the stock becoming worthless---a 200% loss) and leveraging mutual funds (where there is no protection similar to the "cushioning effect" of the discount against further market declines, nor the extra means of profiting like the leveraging of the discount and the shift of the discount to its normal discount). A compelling case to buy CEFs, indeed!

 

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