Leveraging into Equities – The ONLY Source of Wealth?

Ed Rempel, a certified financial planner (CFP) and accountant, is a regular comment contributor to this blog. He is well known for his strong opinions on using leverage for financial gain. Here is an article that he has written on leverage.

I was browsing through Forbes latest list of the 400 richest Americans and it occurred to me that they almost all made it there the same way. Basically, the ONLY way they made it super-rich is by leveraging into equities!

Only 21 inherited it – the rest made it themselves. Many people might assume there would be celebrities, such as movie stars or athletes, but the only celebrity on the list is Oprah Winfrey. Essentially everyone else made it there by leveraging into equities – or inheriting it from people that leveraged into equities.

Most of them made it there by building a business. Nearly all of them started up a company and borrowed to invest in it. And then their business would borrow a lot more money, which is necessary to grow quickly. Making it rich without leveraging is not really possible.

Of the 400 richest, 37 made it there as mutual fund or hedge fund managers, and 22 are investors – all investing in equities. 28 made it in real estate, but really it was by building a real estate company. Even Oprah Winfrey built a media and entertainment business.

Businesses are equities. Whether they borrowed to invest in one business or many, the ONLY real way to major wealth is by leveraging into equities.

This leads to the obvious question – if leveraging into equities is the ONLY “yellow brick road” to wealth, why don’t more people do it?

The answer is fear – fear of leverage and fear of equities – both of which are partially well founded and partially highly exaggerated.

Talbot Stevens wrote that “Leverage is a power tool”, which describes it very well. Nobody questions that a power saw will cut a board quicker, straighter and cleaner than a hand saw. If you are uncomfortable with power tools, you may be scared to use it – and if you use it badly, you could hurt yourself badly.

Leveraging into equities is the same. You may be scared to do it and if you do it badly, then you could really hurt yourself. But in skilled hands, it builds wealth far more quickly and directly. By leveraging, you can make a lot of money with solid investments. Without leverage, you can only do it by buying very risky investments.

There are also all the facts about how terrible most equity investors. Based on the Dalbar study, the average investor averaged 3.5%/year for the last 20 years, while the funds they owned averaged 11%. Buy an average fund and hold it and you make 11%, but the average return of millions of investors is only 3.5%! Why – because most of us actually believe we can successfully market time.

The entire field of Behavioral Finance is very entertaining. It is all about all the cognitive errors we as humans are conditioned to continually make.

However, there are solid investment strategies. There are exceptional investors that beat the markets by wide margins over time. They constantly study the markets and they all can tell you why they beat the indexes. We call them “all-star fund managers”.

You can get over the fear of equities by having a solid strategy, continually studying the market and constantly resisting human tendencies – or you can just hire some of these “all-star fund managers”.

Leveraging into equities is also the main reason for the power behind the Smith Manoeuvre and the Rempel Maximum.

Bottom line – use leverage skillfully and invest either with or like the all-star fund managers – and you can get onto the ONLY road to wealth.

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Ed Rempel

d Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com
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Ed Rempel
9 years ago

Hi Hold,

This particular fund manager has been our core Canadian equity fund manager for 7 years.

Identifying All Star Fund Managers is not as difficult as you think. Fund managers with real skill tend to maintain it. We have been using most of our fund managers for more than 5 years.

You have to know what to look for, though. You have to avoid “closet indexers” and you can’t chase returns by just going with high recent performance.

The most in-depth study on this topic is called “Active Share”. There are several articles on MDJ about it, such as: https://milliondollarjourney.com/truly-acitve-managers-outperform-being-different-is-key.htm .

Ed

hold
9 years ago

Ed,

You make a comment about identifying a star manager.

“I hope you understand why we prefer to keep our specific fund managers confidential. They do exist, however. For example, our core Canadian equity fund manager has earned a cumulative return of 240% this decade vs. only 67% for the TSX60 TR.”

I would like to know if you were using this same fund manager ten years ago?

Ed Rempel
10 years ago

Hi Ron,

Equities are businesses. Having your own business gives you control, but you still have many risks. In most cases, they are far more risky than large mature companies on the stock market.

The returns of mutual funds are always shown after all fees. If the fund averaged 5%, then it actually made 7.5% before fees. That is low by long term equity standards, but not bad in the last decade.

That is enough to make the SM quite profitable long term.

You do need to do your due diligence, but we find that the top fund managers are easily worth their fee. It takes a lot to identify the most skilled fund managers, but there are some that beat the indexes by wide margins over long periods of time after all fees.

Ed

Ron
10 years ago

Ed – you are confusing equities with a business. The wealthy people you referred to who build wealth through their business indeed leverage their equity but they also control their equity. When you invest in an exchange traded stock, you are a minority shareholder with absolutely no power or influence or control over your investment. If the executives decide to pilfer the company’s profits or dilute your shares, you have no say on the matter. With mutual funds, it is even worse. Here, the fund managers will take a management fee regardless of the profits and you have absolutely no control over that. For instance, if the average return per year on a fund is 5% and they are taking 2.5%, you are giving them 50% of your profits with them bearing none of the risk and you bearing all of the risk. Why would anyone leverage in that scenario? The successful business owners I know were all majority owners of the their equity with complete control (or at the very least they were partners with a great deal of control over their investment).

Ed Rempel
11 years ago

Hi Aolis,

I hope you understand why we prefer to keep our specific fund managers confidential. They do exist, however. For example, our core Canadian equity fund manager has earned a cumulative return of 240% this decade vs. only 67% for the TSX60 TR.

It’s standard deviation (risk measure) is 20% lower than the index as well.

Most of their methods are known, but still not followed. For example, Warren Buffett noted 20 years ago that most of the top investors are value investors, but there still is no move toward value investing. If anything, value investing is becoming less popular today, as many investors are focusing more on short term trading and following trends. This is true even though most top investors don’t use graphs or active trading models.

People seem to prefer overly-simplified methods, such as looking at a graph and making an easy (but dumb) trade. Value investing takes work to do properly – but has a much higher chance of long term success.

The long term success of many value investors is well documented. Why isn’t everyone doing it?

Why would the indexes rise because someone is a better stock-picker? Most top investors have portfolios significantly different than the indexes.

You do seem to still really believe the Efficient Market Hypothesis. In recent years, academics have found more and more flaws in it to the point that it is generally believed to be only somewhat true. It seems there are all kinds of documented inefficiencies and ways to beat the indexes.

Robert Shiller from Yale says the EMH “represents one of the most remarkable errors in the history of economic thought.”

Ed

aolis
12 years ago

Ed,

“All-star fund managers” are a myth. I have trouble undertsanding how you can publicly claim to be able to identify them without any proof. If it was so clear, you would certainly be able to give a list?

If they “can tell you why they beat the indexes”, certainly everyone would be able to do the same? Wouldn’t the indexes themselves rise as all these companies started doing so much better?

Much of your advice is very strong so it really suprises me when you pull this out. Is this because getting people to invest with fund managers is how you get paid?

The Rat
13 years ago

Great article FT.

I love leveraging and anything even remotely associated with the discussion of it. There should be more information out there about leveraging as a tool. Its interesting how you mention Talbot Steven…I just ordered a used book by him through Amazon just this past week for $2.95 and looking forward to the read.

Regarding your article, I did not read it to attempt to make a debate out of it; I took it for what it was and the spirit of what leveraging CAN do for an individual’s personal finances and/or business.

Good job in my view. It highlights the reality just how leveraging can be used to one’s advantage and hence ‘shave off time’ for reaching one’s end-goals.

Cheers,
The Rat
P.S. Hit me up on my new site if you get a chance and let me know what you think or post a comment to a post

Cannon_fodder
14 years ago

Ed,

I’ve continued to enhance my calculator originally created to help me understand the Smith Manoeuvre. I’ve attempted to add a checkbox for the Rempel Maximum. But, I’ve run into a conundrum.

If I use typical scenarios where the LOC interest rate is > than the mortgage rate, and if you borrow up to an amount dictated by the principle paydown of the 1st mortgage payment, you quickly run into a negative cash flow impact – in other words, you have to come up with additional money. I’ve also tried it a different scenario where you borrow an amount that requires absolutely no additional cash flow through the entire process and is timed to balance the LOC interest costs with the original mortgage payment.
I’ve put in your numbers using the example above and the cash flow turned negative at the end of the 10th month and grew to require an additional $173 per month once the mortgage was retired.
Of course, one could dip into the anticipated tax refund to help fund the additional cash required.
I’d like to hear from you, the inventor of the process, so that I can properly adjust my calculator.

oOKitijimaOo
14 years ago

Personally, I love leveraging into Equity, maybe because I have not been burned by it yet. Or Perhaps I have properly diversified my portfolio to include Leveraging.

I am not saying I know everything but if you can comfortably utilize leveraging to your advantage without causing the great ship to sink then this is something you might want to consider growing your assets.

falconaire@sympatico.ca: Sandor
14 years ago

I would like to refute my friend CC’s argument in post #1.

It is about the evils of leveraging and CC’s argument goes like this:

I am sorry but I think this argument is a bunch of baloney. Millions of people start businesses and don’t end up on the Forbes 400 list. In fact, most start-ups fail miserably. Warren Buffett, one of the most successful businessmen/investor ever and #3 on the list has this to say about leverage:

“The most dramatic way we protect ourselves is we don’t use leverage. We believe almost anything can happen in financial markets… [so] even smart people can get clobbered with leverage. It’s the one thing that can prevent you from playing out your hand.”

Well, I looked up Warren Buffet’s consolidated balance sheet and found that in 1998 they borrowed $2,385,000,000 for investment purposes.
This is the address:
http://www.berkshirehathaway.com/1998ar/statements.html

In the year 2000 the same liability was $2,663,000,000.
(http://sec.edgar-online.com/2001/03/30/0000950150-01-000114/Section14.asp)

Which means to me that they not only refused to practice what he preaches, but also they increased their borrowing by 278 million in two years.
Admittedly, in view of the company’s success this debt is just a pittance, but they surely wouldn’t have borrowed if the reason were not there. But it was there, they found it reasonable to borrow.

Sandor