Most advisors avoid leveraged products and strategies, and there are two main reasons.
First, “even at big firms, there’s not much opportunity to use leveraged strategies,” says Barnaby Ross, vice-president and investment advisor at RBC Dominion Securities in Etobicoke, Ont. “Funds that do so are looked at with a very critical eye. So, when an advisor chooses to use leverage, it’s not encouraged.”
Over the last 10 years, both MFDA and IIROC have clamped down on advisors who suggest borrowing to invest or other leveraged strategies, he notes. On the IIROC side, the added business risks, red tape and requirements are major hurdles (see “The rules”).
Second, many advisors lack proper knowledge and training, says Talbot Stevens, author and president of a financial education firm in London, Ont. “A lot of advisors think leveraging involves a single strategy, but there are more than 15 different strategies related to borrowing to invest, and each has different pros and cons and risks.”
Still, Ross and Stevens acknowledge that leveraged strategies can help grow and protect clients’ portfolios. Here’s a look at the pros and cons.
Two strategies and your obligations
The most common form of leveraging is borrowing to invest, where clients take out loans—often against home equity or their investments—to increase their wealth. The pros of this are growing the investor’s portfolio and, these days, borrowing at low rates.
But when an advisor helps a client borrow, which increases AUM, regulators can see that as a potential conflict of interest. As a result, recommending the strategy can make it more difficult for an advisor to prove he’s client-focused, says Stevens. “You then need to go beyond the normal standards of educating clients” by creating personalized lists of pros and cons for each interested client, alongside regular disclosure, as well as KYC and suitability checks.
That’s the case whether the advisor or client is the first to bring up leverage and borrowing to invest. IIROC notes advisors should always know and consider their obligations to their clients. Says Ross, “Advisors should document all conversations. It should be noted if clients wish to be very aggressive and borrow a lot of funds, and compliance and several levels of management should be notified. The KYC will reflect the account is high-risk.”
If a client chooses to borrow to invest after all disclosure is made, you must then prepare for “the additional magnification of losses that can occur,” says Stevens. That means doing more than ensuring the client knows she could lose capital if markets drop. The client should also know that if she borrows to invest and then loses, her reaction may be stronger.
To determine how much a client should borrow, find out two things. First, her loss capacity, or how much financial loss she could absorb based on items such as her income, expenses and cash flow. Also, figure out how much she should and is willing to borrow—this amount will likely be smaller—after you also explain the risks of borrowing to invest (see “Some risks of borrowing to invest”).
Stevens suggests a client borrow only a small portion of the total she’s willing to borrow—say 20% to 30%. Then, “if markets dropped, the client wouldn’t be all in,” Stevens says. He suggests a smart debt strategy would be, at the time markets decline, to increase her exposure to 30% or 40% of the total amount she’s able to borrow, provided the fundamentals of the investment are still sound.
“That way, when the markets recover, she’d profit and regain,” he says. But she’d need the right level of cash flow and confidence, so risk tolerance should be assessed again before she borrows more to invest.
If a client is wary, there are other ways to gain from leverage, such as investing in hedge funds that use the strategies. Ross says advisors using leverage are most active in the hedge fund area, and that the leveraged funds must be approved by their firms. “In this area, you can go long, two times leverage, 50% leverage, or you can go short,” among other strategies that can be more aggressive, such as using derivatives to gain leverage.
One of the most prudent ways to take on leverage is through pairs trading, he adds. “That means finding a fund manager that pairs trades, which means he’s long one stock and short another in the same industry, or he might be short an ETF that invests in the same industry.”
This approach is more conservative because the goal is to hedge against losses. For example, if a fund pairs two oil company stocks and both go down, it would lose money on one but gain on the other. This is safer than taking either position on its own.
Still, you’d have to teach your client about derivatives, and inform her about the fund’s strategies and sometimes higher fees. And the paperwork is onerous, says Ross. To invest in such a fund, “the client would need to sign off, saying they [understand they] can lose all their money, even if it’s a conservative hedge fund and if the fund has a tremendous record.”
Plus, “the hedge fund has paperwork that has to be signed as well, which has to […] be approved.” The whole process can take weeks, he adds, unlike “simply buying a stock or mutual fund and knowing you’re going to settle at T+3.”
The keys to using such strategies, says Ross, are knowing which clients have the capacity, tolerance and knowledge to accept risk and, from there, keeping on top of required client documentation and industry research.
IIROC provides guidance in the following areas.
- Borrowing to invest: IIROC expects firms to identify and closely supervise borrowing-to-invest strategies. Notice 14-0044 sets out specific rules for firms and advisors, such as filling out internal borrowing-to-invest suitability checklists, and more regularly monitoring leveraged accounts. IIROC adds, “Leveraging securities [or] investment portfolios for items other than investing in securities falls more on the personal lending side,” and under the jurisdiction of bodies such as OSFI or FSCO.
- Leveraged and inverse ETFs: The sales practice obligations for such funds are explained in Notice 09-0172. IIROC says in the notice that these funds are “growing in number and popularity,” even though they’re sophisticated products. It goes on to say that, “Leveraged and inverse ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”
- Business conduct: Advisors who recommend borrowing to invest, or who know a client intends to do so, must deliver Leverage Risk Disclosure Statements, according to IIROC Rule 29. The SRO prescribes preferred wording for these statements.