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Is leverage suitable for the average client?

Debt can be used to boost returns, but it may not be appropriate for some clients

The use of leverage has a tendency to raise the pulse and ignite anguished debate within the world of investment.

Whatever individual asset manager views are, asset price volatility, the over-pricing of real assets and the direction of monetary policy are the common topics of discussion. However, the one question all too often absent is whether leverage is appropriate for the average end client?

When it comes to tax-efficient investing and business relief services specifically, it is both hugely important and strangely lacking. How comfortable should investors be with structures that have embedded leverage? Do they even realise their investment returns are predicated on the use of debt to boost returns?

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The average customer is likely to be in their 70s and 80s. They are looking to minimise their IHT liability and have probably spent their entire life paying off their liabilities. While there is an increasing prevalence of retired people taking on debt, this often isn’t voluntary – be it equity release to provide additional income or to provide assistance for younger generations to access the property market. For most, “debt” remains a nasty four-letter word.

With this in mind let’s consider the “average” BR investment service, for example in the field of renewable energy assets: valuable, cash-producing assets parked in a limited company paying an income of between 3 and 5 per cent a year after charges and corporation tax.

This isn’t exactly shooting the lights out compared with other risk assets, but for investors its predictable cash flows combined with tax-efficiency makes absolute sense. Dig into these financially engineered vehicles, however, and you quickly realise that many providers have layered on debt to get returns up to that 3 to 5 per cent level.

Why risk a modest return – compared with other higher risk assets – by using debt with a potential of extra volatility?

So why do managers use leverage? Fundamentally, debt is used to increase returns, albeit this will only be achieved if debt costs are lower than the return. Debt can also be used to achieve scale faster; high levels of debt enable the manager to buy bigger or more assets than would otherwise be possible with just equity funding.

The question advisers should be asking themselves is that if returns are “only” going to be 3 to 5 per cent, why risk this relatively modest return – compared with other higher risk assets – by using debt, given the potential of increased volatility? In the same vein, advisers should look at providers (such as Triple Point and TIME Investments) who don’t use leverage, and consider whether their returns should to be viewed through the same prism as those that do.

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At the risk of generalisation, the older risk-intolerant IHT investor will rarely realise the risks of using leverage. They will not appreciate that debt magnifies the effect of valuation movements. They will fail to realise that if renewable energy values fall, the net asset value impact is magnified by the presence of debt. As a group, they tend to be more concerned about losing capital than achieving high returns and as a result, would expect their adviser to reduce their risk position by recommending an unleveraged service.

I am not suggesting debt is always inappropriate – far from it. Leverage can make sense in many circumstances, particularly with more experienced investors, who understand what can go wrong. I will leave you with a quote from Warren Buffett, who perhaps summarised it best: “When you combine ignorance and leverage, you get some pretty interesting results…”

Tony Mudd is the divisional director for development and technical consultancy at St James’s Place

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