Buffett’s Thoughts on Investing with Leverage

Warren Buffett began investing in stocks over 70 years ago. At the tender age of 11 years old, the Oracle of Omaha made his first equity purchase. He bought three shares of Cities Service Preferred. He sold his shares early and made a tiny profit. But more importantly, he learned a great lesson about patience as he watched shares in the company soar much higher. Over the years, Buffett has shared this wisdom with other investors.

One of the most important investments to learn from the billionaire phenom has everything to do with leverage.

“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious,” explained Buffett in his 2010 shareholder letter. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

Primarily, Buffett was talking about leverage and how it relates to personal debt, but you can apply this same principle to ETFs – exchange traded funds – which is a relatively new product in the financial world. A leveraged ETF ultimately equates to a regular ETF, but it has impatience and greed written all over it. This particular type of exchange traded fund looks to deliver multiples of the underlying index’s performance, or whatever benchmark they happen to track. Some ETFs will track broad indices, and there are others that track certain commodities and sectors. A leveraged ETF specifically seeks to magnify the returns by using derivatives, Wall Street’s favorite financial drug, as well as swaps and futures contracts.

For day traders, a leveraged ETF has quite a meaningful purpose. But as a long-term investor, you’re better off steering clear. As an example, let’s come to the conclusion that an index starts with a value of 100. A leveraged ETF looking to double its return starts at $100 in this example. If the index sees a 10 point drop on day one, the value drops to 90 points, or 10%. In this theory, the leveraged ETF actually loses 20% on the same day, because the drop in the index is felt twofold. Your shares will only be worth $80 now. Let’s say on day to the index rebounds and goes up 10%. That will make the index value go to 99. Even though the second index will increase by 20%, the 20% addition from $80 only turns out to be $96.

On a daily basis, the leveraged ETF achieved its goal. But it was not capable of keeping pace over two days. For a buy-and-hold investor, this gap will grow significantly over time, and it can be a serious issue in volatile markets. An investor could potentially suffer significant losses even though long-term performance for the index could show a gain.

Leveraged ETF’s dangers have been highlighted over the years recently, but investors and brokers are still learning things the hard way. Century Securities and Stifel Nicolaus were recently ordered by the Financial Industry Regulatory Authority in the amount of over $1 million because of unsuitable sales of inverse or leveraged ETFs. A total of 65 customers were involved between the two brokers based out of St. Louis.

The Chief of Enforcement and Executive Vice President of FINRA, Brad Bennett, explained, “The complexity of leveraged and inverse exchange-traded products makes it essential for securities firms and their representatives to understand these products before recommending them to their customers. Firms must also conduct reasonable due diligence on these and other complex products, sufficiently train their sales force and have adequate supervisory systems in place before offering them to retail investors.”

Between January 2009 and June 2013, FINRA found that the two brokerages mentioned above made inappropriate recommendations to purchase these nontraditional ETFs to specific customers and some of the representatives didn’t fully understand the unique features or risks involved with inverse and leveraged ETFs. These particular customers had conservative investment objectives; they experienced net losses and suffered more than others.

Prior to investing in a leveraged ETF, it would be wise to really consider what might happen if you plan to hold the shares for longer than one day. Do the extra risks fit in with your financial goals? These ETFs also have higher fees than traditional ETFs in many cases.

We all want to build wealth quickly. Like Warren Buffett, it may take decades to accumulate the amount you desire.