Academic research indicates greater risks due to lost opportunities and trading costs
While the use of leverage might be an effective way to amplify returns, it could also magnify the pain of investment losses. And according to new academic research, that double-edged sword is much sharper on the losing end.
In an academic paper published in May, researchers from the University of California, Tsinghua University, Beihang University, and Nanjing University analysed futures trading records covering the period from January 2, 2014 to December 30, 2016. The data, obtained from an unnamed Chinese brokerage firm, was made up of 39.4 million futures trading records from 10,822 investors, including 315 institutions.
As reported by Institutional Investor, the researchers found that a one-unit increase in leverage “implies” a 3.3-basis point reduction in an investor’s daily gross returns, and a 5.35-basis point decrease in net returns.
Extrapolating the results to an annualized timeframe, the paper said applying similar leverage each day would accumulate into 8% underperformance for gross returns, and 13% for net returns, for each added unit of leverage.
“The higher is the leverage, the higher is the probability of being mandatorily liquidated,” the researchers said.
Such liquidations end up being a double-whammy for investors, the paper said, as they crystallize losses and lose the opportunity to participate in potential price rebounds. The average percentage loss in daily returns from such forced liquidations, on both a gross and net basis, was calculated to be more than 26%.
Higher trading costs were another factor that ate away at performance. The researchers found that because of such costs, decreases in net returns ended up being larger than gross returns.
“Large leverage enlarges trading positions, and hence should increase trading costs compared with those without leverage,” the paper said.
Based on their findings, the researchers concluded that while added risk is expected to result in higher returns, it’s not so true when it comes to the use of leverage.
“For the majority of investors, leverage reduces trading performance, although it makes investment returns more volatile,” they said.