A Better Way to Use Leverage in Your ETF Portfolio

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Leverage can magnify a portfolio’s performance for better or worse. Poor results have sunk many leveraged ETFs. So, how can an investor use leverage to optimize their investments instead of destroying them? Bryan Armour is the director of passive strategies research for North America for Morningstar Research Services. He’s also the editor of Morningstar’s ETFInvestor newsletter. We talked about a better way to use leverage.

Great to see you, Bryan.

Bryan Armour: Thanks for having me.

Why Leverage Has a Debatable Reputation in Investing

Hampton: Let’s start today with what is leverage and why does it have a debatable reputation?

Armour: Leverage basically is borrowing money to invest. So obviously that ends up magnifying returns because you’re using less money to gain more exposure, which is effectively what leverage is. Leverage comes at a cost, and so obviously when you’re borrowing from someone, they want to make money lending it to you, they also want to make sure that they don’t lose their money, and so there are risks on their side as well as yours. So, one of the issues is when markets sour, then they’re more likely to want their money back, and so that can end up having a compounding effect: Your investment’s losing money and it also becomes more expensive to employ leverage.

That‘s why leverage traditionally has been at the center of a lot of different market downturns. Whether it be unregulated margin accounts during the Great Depression or Lehman Brothers’ highly leveraged balance sheet in 2007. There’ve been many times where leverage has been at the center of these market crashes. But likewise, we also use leverage in our daily lives. We have mortgages, we have credit card bills, and so it’s a strange dichotomy. Warren Buffett uses leverage in Berkshire Hathaway, so there are all sorts of different sides to leverage, but obviously it has a bad reputation for its role in market crashes.

Volatility Drag and Leveraged ETFs

Hampton: Would you say another reason for its reputation is because of the so-called volatility drag and how some leveraged ETFs reset their exposure?

Armour: So, in the ETF world, leveraged ETFs often or traditionally were like 2 times S&P 500 ETF or any type of strategy or asset under the sun at this point. But what they do to achieve daily leverage is they reset swaps every day. So, it goes up, they need to add more exposure. If it goes down, they take exposure off. What happens is in choppy markets when the underlying asset’s going up and down is you’re buying high and you’re selling low on repeat as they’re adjusting the exposure. So, that ends up having a significant drag on performance and one that’s killed a lot of different leveraged ETFs over time.

Why Does Leverage Kill ETFs?

Hampton: You say leverage kills ETFs. We just were talking about this off-camera. When has that been the case and what do the returns look like, Bryan?

Armour: It happens quite often, unfortunately. Nearly half of US leveraged ETFs and exchange-traded notes, so together ETPs, have closed and 13% of all leveraged ETPs have returned negative 98% or worse since inception. So, there’s obviously a long track record of this behavior and where volatility decay over time really destroys their performance. That’s why they’re required by regulators to say daily 2 times leverage because they’re not intended to be held longer than a single day.

What Are ETPs?

Hampton: Got you. When you say ETPs, you mean what?

Armour: Exchange-traded funds and exchange-traded notes together, yeah.

A Better Way for Investors to Use Leverage in Their Portfolios

Hampton: Awesome. In the September edition of the ETFInvestor newsletter, you wrote that there‘s a better way to use leverage and it would require creating an optimal portfolio that aligns with investors’ stomach for risk. Can you give us an example?

Armour: The classic academic example is called the efficient frontier. You take various different types of portfolios and you sort of plot them based on the risk and return, and then you look at which one has the highest return for the amount of risk it takes. So, if you think of you have three portfolios, one has 0% in stocks, 100% bonds, you have a 50/50, and then you have 100% stocks, 0% bonds. The 100% stock portfolio is going to have the highest return but also takes the most risk. So, if you’re willing to take that much risk, then what you should look for is the highest return as a unit of risk and then lever that up to the return of the 100% stock portfolio, 100% stock portfolio. So what that does is it looks at Sharpe ratio, which we talk about a lot, which is risk-adjusted performance or returns. You can use leverage to reach that same level of risk but receive a higher total return at the end of the day.

How Can Investors Add Leverage to Their Portfolio Without Volatility Drag?

Hampton: What are some ways an investor can add leverage to their portfolio minus that volatility drag?

Armour: Volatility drag can still make its way in no matter what, but the classic way is margin. So, if you think personal brokerage account, you can add margin that allows you to borrow money you can then invest. That’s one way to get leverage. Then derivatives are another popular option, so think options, like each stock option you buy gives you the right if it’s a call option to buy 100 shares of the underlying stock. So that provides leverage in that way. Then futures swaps are also other derivatives that provide leverage. Then you can also do leveraged ETFs. So not always just the 2 times whatever, but daily reset, but there are ETFs that employ leverage in different ways.

Costs of Leveraged ETFs

Hampton: I’m going to bring up something that comes up every time you’re here, costs, because they matter too. Which one of those choices you just named would give investors the most bang for their buck?

Armour: Margin accounts, if you’re an investor with a brokerage account at Fidelity or E-Trade or Vanguard or Schwab, you could be paying 12% to borrow those funds. So, that is not an efficient way to gain leverage. 12% is going to be a high bar that’s difficult for investors to consistently beat on their investments to outearn that cost of leverage. Options might be a little bit better, but there’s a complicated return profile with options. If you look at something like futures, that’s going to be the most efficient, it’s a highly liquid underlying market. Then there’s also, there’s institutional borrowing costs embedded in the futures price. It’s going to be more like right now like 5.5% versus 12%, which is obviously significantly different. So, futures are more efficient, and swaps are really just out of retail investors’ reach other than through ETFs.

How Most Investors Should Gain Exposure to Leverage

Hampton: What type of investors should consider using leverage? I mean, are you a DIYer or am I going to my financial advisor?

Armour: Well, DIYers should be very careful operating leverage on their own just because these costs aren’t always obvious, and also you can be stuck when I talk about the compounding impact of leverage when markets go down, you could get a margin call when you weren’t expecting it. There are just potential issues and maintaining the correct leverage and managing that can be very difficult. So DIYers, it’s going to be tough. Financial advisors, they don’t spend a ton of time trying to figure that out, either. So, I don’t know that that would be that much better. It really comes down to, for most retail investors, an ETF or leverage through a mutual fund would probably be the best way of gaining exposure.

Do Leveraged ETFs Show Promise?

Hampton: Bryan, what leveraged ETFs have shown promise in Morningstar’s opinion?

Armour: We’ve dug into a couple of different series that have shown more promise than your typical daily reset, 2 times leveraged ETF. Those would be the WisdomTree core efficient funds, and then also the newer return stacked ETFs, which are for WisdomTree they’ll use futures to gain additional increment of exposure, think about a 60/40 providing exposure up to 90/60. Then for return stack, they look to add 2 times exposure for a single dollar. So, regardless of whichever assets you choose within that mix, you get a little bit more exposure by the use of futures, which as we said was the most optimal way to use leverage.

Hampton: Well, Bryan, thank you for coming to the table and explaining how we can use leverage to optimize our portfolio instead of destroying it.

Armour: Yeah, absolutely. Anytime.

What’s Coming Up in the Markets?

Hampton: Here’s the markets in brief for the week ahead: Wall Street will debate the Federal Reserve’s next interest-rate move. The Fed is scheduled to start its two-day meeting on Wednesday, Nov. 6. They’re expected to announce their interest-rate decision on Thursday. They cut rates by half a percentage point in September as they shifted their focus from inflation to the job market.

Big Tech is turning to nuclear energy to power the AI boom. Microsoft, Amazon, and Google are partnering with utilities and others to quench data centers’ nonstop thirst. But could the tech companies’ investments revive a broader interest in nuclear energy? And which utility could sign a deal next? Travis Miller is a strategist for Morningstar Research Services and covers energy companies. We talked about the growing demand for carbon-free energy.

Welcome back to the podcast, Travis.

Travis Miller: Thanks for having me.

How Much Energy Does a Data Center Need to Run?

Hampton: Now, we’ve talked before on the podcast about the electricity needs for the AI expansion. I want you to help us picture how much energy a data center needs to run 24/7. What is that equivalent to in our everyday lives?

Miller: Some of these numbers are just incredible that we’re seeing, and it’s kind of fun as a utilities analyst here because we’ve never had electricity demand, projected growth or growth opportunities like this in a long, long, long time. Even back to the Industrial Revolution, some of these numbers that utilities have thrown out on data centers is incredible.

So, probably the best bring-it-home literally is a typical home uses kind of 10 kilowatts. So when you’ve got all this stuff running in the middle of the day, maybe even in early afternoon, 10 kilowatts. Some of these data centers, the large ones, you’re going to do 150,000 kilowatts at their peak.

Hampton: Wow.

Miller: You look, even more expanding that, a large data center right now in Virginia uses about 50 times the electricity as an equivalent square foot of office building space. For every square foot of data center, using 50 times the electricity of a square foot of an office building, regular office building.

In Northwest Indiana, so Microsoft has a deal and a proposed plant or data center there. The utility in Northwest Indiana has said two to three data centers of these hyperscale type level data centers will double demand electricity demands in Northwest Indiana. Eight data centers, which they’re negotiating in probably 2035, so we’re still talking decade, decade and a half out, would quadruple electricity demands in Northwest Indiana.

So, you can start extrapolating these, and with all of the discussion about how many data centers might go up, how many data centers are going to be needed for AI and all these other digitization applications, the electricity numbers get really, really, really big really fast.

Why Small Modular Reactors Could Be Key to Powering Data Centers

Hampton: For sure. Well, Amazon and Google have recently signed nuclear deals with providers. The focus is on small modular reactors, also known as SMRs. Talk about what’s significant about this next-generation technology and when these reactors could come online.

Miller: Given what we just talked about, in terms of the amount of electricity needed to bring just a single data center online, wind and solar are not going to get it done. And really that’s all any utilities are building right now and frankly, that’s all the governments either state or federal will allow utilities to build for the various environmental reasons. Wind and solar, not only are they too small, they only run when the sun shines and the wind blows. So, that’s not when data centers want to run. Data centers want to run 24/7, and the wind and the sun don’t shine 24/7.

So, utilities and data centers, operators, the developers, Microsoft, Amazon, Google, they’re trying to find some way to get all of the electrons that they need to run these data centers. The options right now, really, are natural gas and something else, and that’s the big something else. And small modular reactors are part of that something else. SMRs have been around for a long, long time. The technology has been around for a long, long time. Utilities have studied using them in certain applications for a long, long time. Utilities have never had the amount of demand and challenges serving that demand as they might in the next decade with data centers. So, utilities are looking at any solution and SMRs are a technology that’s been around and could be a solution, although they’re very, very, very expensive.

Hampton: So, let’s see, it’s 2024. So, 2034?

Miller: That’s the big challenge. We got a real pull here. This dynamic between the data center developers and all the tech companies who want their data centers online right now. They want all their electrons right now. They want to start producing all these big models, et cetera. And the utility’s saying, “Well, I don’t know, this might take us four or five years to build a power plant. To build an SMR.” SMR is not only do you have to develop the technology, get really a private investor—utilities are not going to do and have said for many years they’re not going to do SMRs, there’s too much risk around it. So, you’ll need a developer, you’ll need a technology provider in terms of SMR technology provider. And then they have to work with the utilities to actually integrate them with the grid to serve the data centers. Put all that together, nothing happens quickly in utilities. And you’re absolutely right that we could be talking five-plus years before a single SMR were to come online at the fastest.

Are Carbon-Free Pledges Driving Companies Toward Nuclear Energy?

Hampton: Definitely some wait-and-see. Well, these companies have pledged to become carbon-free at some point. Do you think that’s the reason that’s driving them toward nuclear energy?

Miller: Yeah. And that gets back to the idea of what are you going to choose to produce electrons. So you’ve got, again, solar, you’ve got wind. Those don’t really serve data center needs. So, carbon-free, yes, it’s great. Data centers can’t use that for their electrons. Natural gas has carbon emissions, low carbon emissions, but still carbon emissions. So, that’s not going to solve the carbon-free piece of the puzzle. Nuclear carbon-free, whether that’s large utility-scale nuclear or the SMRs, again, it’s the only thing left in the toolbox for utilities to provide electrons to data centers. And that’s what data centers want: carbon-free electrons. So, solar and wind aren’t going to get it done. Nuclear either large-scale or small-scale is going to have to be a solution if those data centers want to continue being carbon-free.

Which Utilities Companies Are Next to Sign Data Center Deals?

Hampton: And which utilities are waiting on the sideline? I mean, who could sign a deal next?

Miller: Just about every utility, yes, has some kind of data center. Except for certain areas of the country where electricity is already really expensive. Again, I don’t think we’ll see utilities directly investing in either SMRs. I don’t think we’ll see them investing directly in large-scale new nuclear. Natural gas seems to be the preferred generation, incremental source of generation, solar, wind, but that’s not going to get it done. So we really are, I think all the analysts are kind of searching for who’s going to be the next utility to solve this problem, essentially. All these utilities have some substantial electricity demand needs over five, 10 years.

Southern Company SO in Georgia talking about 7 gigawatts, and to give you a sense, the largest nuclear plant, they just added half and is now 4 gigawatts. The largest nuclear plant in the US just over 4 gigawatts and they had just doubled that, Southern Company. And they have 25 gigawatts of potential pipeline data center demand. SMRs can’t come close to that. SMRs are less than a gigawatt. So you need a lot of SMRs, a lot of gas, a lot of solar, a lot of winds to make any of these data centers viable. Big challenge.

Is This Shift Toward Nuclear Energy Larger Than Just AI?

Hampton: Are we witnessing a seismic shift when it comes to nuclear energy or is this really tailored to data center demand?

Miller: I think this is really tailored to data center demands. We think that core demand, electricity demand growth’s only going to be about 1%. The other wild card here to think about is EVs. And the data center thing has kind of pushed EVs to the side, and we’ve seen some slack sales on EVs, so that’s kind of out of the headlines. But in our calculations, EVs could ultimately in the next decade or more, be more of an electricity demand issue than data centers.

So, data centers have massive numbers out there. There are issues like we discussed. There are issues with actually getting electrons to the data centers. There aren’t those issues with getting electrons to EVs for most people who are charging at home, most people charging maybe in parking lots or shopping malls, the electrons are already flowing there. You don’t need a lot of generation, new generation in very specific places to serve EVs.

We think EV demand, electricity demand could quadruple just in a pretty normal environment, continued sales over the next decade plus. Now EVs are a very, very, very small part of total electricity demand right now, less than 1%. If they quadruple, they still only get to 3% or 4%. But that’s what happens to data centers. Data centers only get to 4% or so of total electricity demand in a decade.

So, there’s this real fight between who’s going to be the demand driver over the next decade for electricity. Is it data centers or is it EVs? I don’t know that both can survive. I don’t know that utilities can serve both, but it is important to recognize the differences there.

What to Look for in Utilities Companies’ Earnings

Hampton: Well, you‘re going to have to watch, you’ve got to tell us what the results are going to be on that. So we’re taping this conversation right now, Wednesday, Oct. 30, and a handful of energy companies are going to report. Dominion D, Duke DUK, talk about what you want to hear from these management teams in early November.

Miller: I think it goes directly to what we were talking about is how are you going to serve electricity and demand growth. Dominion serves what we call Data Center Alley. It’s the largest concentration of data centers in the world right now in Northern Virginia. So, they have the experience in terms of serving these large-load customers. That said, there’s not a whole lot of incremental land, incremental infrastructure where we’re going to see the hypergrowth on data centers in Northern Virginia.

But it is going to be interesting to hear from Dominion over the next several quarters about how they serve demand for data centers, how they might be able to help other utilities serve that demand. Can they continue serving demand as these data centers want more clean energy? Dominion right now is building one of the largest offshore wind projects in the world, in part because their data center customers want clean energy. They’re also one of the largest solar developers. You see a lot of wind and solar coming into Virginia and that surrounding area. It’s becoming very expensive, as we’ve seen from some of the price signals here in the last several months. So, watch Dominion.

Duke is one of those, if you put Duke and Southern, NiSource NI, several of these Midwest, mid-Atlantic utilities, I think that’s where you’re going to see some of this new data center growth. So, we’re going to hear from them about how they plan to serve brand-new large-load.

Utilities Stock Picks

Hampton: And what energy companies does Morningstar consider undervalued at this time?

Miller: No surprise, we do think there are several really good values where data centers are coming in. Again, electricity demand growth solves a lot of problems for utilities. It creates earnings growth, it creates dividend growth. It could improve regulatory relationships. It could lower customer bills depending on how the calculations go. A lot of things are still unknown, though. There’s a lot of discussion about how do you charge data centers? If utilities go out and spend billions of dollars to hook up a data center, who pays for that? Does the customer at home pay for that? Does another business pay for that or should the data center pay for it? So there’s still a lot of that going on.

I think if you look at four names, we’re talking about NiSource in Northwest Indiana. I mentioned that, a lot of growth there. We think they could get up to even 8% earnings in dividend growth for a decade. They just extended their growth outlook and more potentially is coming. Duke Energy is one, also a lot of growth there from just core electricity demand growth as well as data center opportunity. WEC Energy WEC, so up in Wisconsin, again, another data center story. Southeast Wisconsin is becoming a data center hub. Microsoft also getting into data centers in that area of the country. And then Evergy EVRG is an interesting name that we haven’t talked about a lot, but based in Kansas and Missouri, go figure, they also have a data center that could be coming in to that area. And they’re seeing surprisingly strong core commercial, industrial, and residential growth there. If they can improve the regulatory environment in Missouri and Kansas, there’s a lot of growth upside in terms of earnings and dividends.

Hampton: Well, Travis, thank you for coming to the table today and explaining the latest on data centers and energy demands for them.

Miller: Sure. Thanks for having me.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.