A Better Way to Use Leverage in Your ETF Portfolio
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Please stay tuned for important disclosure information at the conclusion of this episode.

Welcome to investing in sites. I'm your host, ivana hampton. Leverage can magnify a portfolios. Performance, or Better or worse or results have suck many leverage etf.

So how can invest or use leverage to optimize their investments instead of destroying them? Brian armor is a director of passive strategies research for north amErica for more star research services. He's also the editor of morning stars etf investor newsletter. We talked about a Better way to use leverage. Great to see, right?

Yeah, thanks for every me.

Let's start today with what is leverage and why does IT have a debate reputation?

A leverage basically is borrowing money to invest um and so that ends up magnifying returns because you're you're using less money to get gain more exposure um which is effectively with leverages and leverage comes at a cost. And so um 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's um risks on the side as well as yours.

Um and so when one of the issues, when markets shower, then they're more likely to want their money back. And so that can end up um having a compounding effect is your investments losing money and IT also becomes more expensive to employee leverage. And so that's why leverage traditionally has been at the center a lot of different um h market downturns.

So IT whether be on regulator margin accountant said during the great depression or lemon brothers leverage baLance sheet in two thousand and seven. And so there have been many times where um leverage has has been at the center of of these um market crashes. But likewise we also use leverage in our daily life.

We have mortgages, we have credit card bills um and so it's it's it's a strange economy. Warm buffer uses leveraging bircher hathaway. So it's all sorts of different um sides to leverage. But uh obviously IT has a bad reputation for its um it's it's wrong market crashes.

Would you say another reason for its reputations is because the so called volatility drag and have some leverage E T S reset their exposure.

Yeah so in the etf world, leveraged E T S often are traditionally were like two times S M P five hundred etf um or or any type of strategy um asset under the sun at this point. But what they do to achieve daily leverage is they reset swap every day. So IT goes up, they need to add more exposure.

IT goes down, they take exposure off. And so what happens is in choppy markets, when you know the underlying assets going up and down is you're selling high are sorry, you're buying eye in your selling low on repeat um as they are the exposure. And so that ends up having a significant drag on performance and one that's um no killed a lot of different log T F over time.

And you say leverage kills E T S. We're just talking about this off camera. When has that been the case? What do the returns look like, brian?

So IT happens quite often, unfortunately. Um nearly half of U S leverage E T S and exchange trade notes. So together E T P um have closed and thirteen percent of all leverage tps have returned negative ninety percent or worse and inception.

So there is obviously a long track record of of this behavior and were vitally to k over time, really destroys the performance. And that's why they are required by regulators to say daily two times leverage um because are not intended to be held monger than A A single day. I and .

when you say E T P, you mean what .

exchange trade funds and exchange trade notes together?

Ah so so in the september edition of the etf investor newsletter, you wrote that there is a Better way to use leverage and IT would require create optimal portfolio that allies with best or stomach for risk. Can you give us an example?

Yeah so the classic academic example, it's it's called the efficient front. You take various different types portfolios and you sort of plot them based on the risk and return and then you look at which one um has the highest return for them on a risk IT IT takes. So if you think of like you have uh three portfolios, one has zero percent stocks, hundred percent bonds. You have a fifty, fifty and then you have hundred percent stocks, year percent bonds. Um the hundred percent stock portfolio is going to have the highest return, but also takes the most risk. And so if you're willing to take that much risk, then what you should look for the the highest return as a unit of risk and then level that up to the return of the hundred stock portfolio hundred percent stock portfolio um and so what that does is IT looks at carper tio, which we talk about a lot, which is risk adjust the performance a returns and you can use leverage to reach that same level risk but receive a higher total return at day.

And what are some ways an investor can add levers to their portfolio minus that volatility drag yeah .

the study drag can still make its way in no matter what. But um the classic way is margin. So if you think personal, you know a broker account, you can add margin that lows you to borrow money, you can then invest um and so that that's one way to get leverage um and then derivatives are another popular option. So think options you like, each stock option you buy um gives you the right, if it's a call option to to buy a hundred chairs of the underlying stock um so that provides average in that way and then future swap are also other derivations said provide leverage um and then you can also do leverage etf so not always just the two times whatever, but daily reset um but are etf employee leveraged in different ones?

Well, I ve gona bring up something that comes up every time you're here. Cost because they matter to which one of those choices you just name. We give investors the most bank .

for their buck yeah. So margin accounts, if you're investor with their brokers account finale or e trade or van garder swab, you can be paying twelve percent to borrow those funds. And so that is not inefficient way to gain leverage.

Twelve percent is going to be a high bar that, that's difficult for investors to consistently be on their investments to to alter in that leverage cost of leverage. So options might be a little bit Better, but there is a complicated return profile with options. You look at something like futures um that's gonna the most sufficient.

It's highly liquid um underlying market. And then there is also um you know there's institutional borrowing cost embedded in the futures Price. So it's it's going to be more like right now like five half percent over twelve percent, which is obviously significantly different. Um so futures are more more efficient. And and so you know swap are really just out of retail investors reach other than through E T S.

So what type of investors should consider using leverage? I mean, are you A D I wire or am I going to my financial of adviser?

Well, di wire should be very careful um Operating leverage on their own just because these these costs are always obvious and also. You can be stuck when I talk about those the compounding um impact of leverage when markets go down. Uh, you could get a margin call when you weren't expecting IT.

Um there are just potential issues in maintaining the correct um leverage in managing that can be very discount. So D I wires, it's gonna be tough financial advisers. They don't spend a ton of time trying to figure that out either.

And so I don't know that, that would be that much Better. Um IT really comes down to for most retail investors in etf. Um our leverage through a mutual fund would probably be the best way of of gaining exposure.

Brian, what leverage etf have shown promise in morning stars opinion?

Yeah so we've duggin into a couple different series that um have shown more promise than your typical daily reset two times leverage etf um and those would be the wisdom tree coefficient um funds and then also the newer return stack E T S switch um for wisdom tree IT will use futures to gain additional equations of exposure. Think about like a sixty forty um providing exposure up to ninety sixty and then um for for return stack, they look to add um two times exposure for for a single dollar. And so um regardless of whichever assets you choose within that mix, um you get a little bit more exposure by the use of future, which as we said was the most optimal um waited to use average.

Oh, brian, thank you for coming to the table and explaining how we can use levels to optimize our leo instead .

of destroying IT. Yeah absolutely anytime.

Here's the markets and free for the week ahead, wall street will debate the federal serves next interest rate move. The fed is scheduled to start this two day meeting on wednesday, november six. They're expected to announce their interest rate decision on thursday.

They cut rates by a half a percentage point in september as they shifted their focus from inflation to the job market. Now big tech is turning to nuclear energy to power the A I bone. Microsoft, amazon and google are partnering with utilities and others to quint data centers, not stop there.

s. But could the tech company ese investments revive a broader interest in nuclear energy and which utility could sign a deal next? Travis Miller is a tragedy for morning star research services and covers energy companies. We talked about the ground, a man or carbon free energy. Welcome back to the park.

Cast travis. Now we've .

talked before on the park care about the electricity need for the A. I expansion. I want you to help us picture how much energy a data center needs to run twenty four or seven. What is that equivalent to in our everyday lives?

Yeah, some of these numbers are just incredible that we're in this kind of find as the utilities and analysts here because we've never had electricity demand projected growth or growth opportunities like this in a long, long, long time being back to the industrial revolution. This is some of these numbers that utilities are thrown out on data centers is incredible. So probably the best um bring at home literally is a typical home uses kind of ten kilowatts.

So when you got all the stuff running and middle of this day, maybe even in early afternoon in ten kilowatts, some of these data centers of large ones can do one hundred and fifty thousand kilos at their peak wo you looked even even more expanding that um a large data sign right now in Virginia uses about fifty times the electricity as a equivalent square foot of office building space a for every score foot of data center using fifty times the election icy of a score foot of a office building, regular office building in north west in Diana. So microsoft has a deal and proposed plant our data center there. The utility in north of Daniela has said two to three data center of these hyper scale type level data centres will doubled demand electricity demands in northwest inDiana, eight data centres which are negotiating in probably twenty thirty five.

So we're still talking and would quite the rule element acy demands in north inDiana. So you can start extrapolating these all of the discussion about how many people might go up, how many dates are going to be needed for A I and all these other digital ization, uh, applications. The electricity numbers get really, really, really big.

really fast for sure. What amazon and google have recently signed nuclear deals with providers. The focus is on small modular reactors, also known as S M R. Talk about what's significant about this index generation technology and when these reactors could come online.

yeah. So given what we just talked about in terms of the amount of electricity need to bring just a single data center online when and solar not gonna IT done. And really, that's all any utilities are building right now.

And Frankly, that's all the governments, either stay or federal, will allow utilities to build for the various environmental reasons. When and solar, not only are they too small, only run when the sunshine in the wind blows. So that's not when data centers want to run data, just want to run twenty four seven and the wind and the sun on shine twenty four seven.

So utilities and data centres, Operators, the developers, microsoft, t damage on google, are trying to find some way to get all of the electors that they need to run these data centres. The the options right now really are natural gas and something else. And that's the big something else.

And small under the reactors are part of that, something else. Emirs have went around for a long, long time. The technologies has been around for a long, long time.

Utilities of studied using them in certain applications for a long, long time. Utilities have never had the amount of demand and chAllenges serving that demands as they might in the next decade with data centers. So utilities are looking at any solution and S M S or technology that spend around and could be a solution, although they're very, very, very expensive.

So you see it's twenty twenty four or twenty thirty four.

That's that's the big chAllenge. We we ve got a real poll here, uh this this dynamic between the data center developers and all the tech companies. We want their data centers online right now.

They want all their electrons right now. They want to start producing all these big models. And the utilities saying, well, I don't know, this might take us for five years to build a powerpoint to build in us.

M R S M R is not only do you have to develop the technology, gets a um really a private investor. Italians are not going to do and have said for many years are not going to do S M R S. Too much risk around IT.

So you need a developer, you need a technology provider, terms of best of our technology provider. And then they have to work with the utilities to actually integrate 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 S M, R were to come online at the fastest.

Definitely some way to see. Well, these companies have pledged to become carbon free at some point. Do you think that's the reason as driving them? Tods nuclear energy?

yeah. And that gets back to the idea of what are you going? Na choose to produce electrons, right? So you get, again, all wet wins.

Those don't really serve data center needs. So carbon free, yes, is great. Data signers can use that for their electrons.

Natural gas says carbon emissions, low carbon emissions, was still carbon emissions. So that's not going to solve the carbon free piece of the puzzle. Nuclear carbon free, whether that's large till you scale nuclear or the S M R S.

Again, it's the only thing left in the toolbox for utilities to profile electron's two data signers, and that's what data signers want, is carbon free. Electrons of solar and wind aren't going to get IT done. Nuclear that a large scale or small scale is going to have to be a solution if those data signers want to continue being carbon free. And which .

utilities are weight on a side light. I mean, who could sign a deal next?

Just about our ref. Dell, yes, as some kind of data center, then they pitch, except for certain narrow, the country where electricity is already very expensive. Again, I don't think we'll see utilities directly investing in either S M S. Think we'll see them investing directly in large scale new nuclear um natural gas seems be the the the preferred generation incremental source of generation solar winds. Um but that has not gonna done.

So we really are I think all the analysts are kind of searching for who's gonna be the next utility to solve this problem is actually all these utilities have some substantial electricity demand needs over five, ten years. Southern company and George talking about seven, give water and give you a sense, the largest nuclear plant, they just added half and is now four gigawatts. Largest nuclear ground in the west, just over four gigawatts, and they had just doubled that southern company.

And they have twenty five gigawatts of potential pipeline data centre. The men as some mars can come close to, as some mars are license than a gig lot. So you need, you are a lot of assur, a lot of gas, a lot of solar, a lot of winds, to make any of these data centers viable. Big chAllenge. Are we witnessing a seismic .

shift when IT comes to nuclear energy? Or this really tailor to data center demand?

I think this is a really tailor to data center demands. We think that core demand, electricity demand girls only going to be about one percent. The other wild card here to think about his evs and the data kind of thing is kind of pushed evs to the side.

And we've seen some slack sales on E V S. So that's kind of out of the headlines. But in our calculations, evs could actually ultimately, in the next decade or more, be more of an electricity demand issue than data signers.

So data signers massive numbers out there. There are issues like we discuss their issues with actually getting electrons to the data centers. There are aren't those issues with getting electron is too e or most people who are charging at home, most people charging maybe in parking, a lot shopping, the electrons are already following there.

You don't need a lot of incremental generation, new generation and very specific places. The service, we think E V demand, electricity demand could quite grup 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. And right now, less than one percent. If they quite rule, they still only get to three or four percent.

But that's what happens. The data centers, data signers, only get to four percent or so a total electricity demand in a decade. So there's this real fight between who's gona be the demand driver over the next decade for electricity is that day designers are as IT evs.

I don't know that both can survive. I don't know that utilities can serve both. But IT is important to recognized the differences there.

What you're going to have to watch yeah tell us what's the results are gonna on that. So we're tape in this conversation right now wednesday, october thirty, and a handful of energy companies are gonna report a domain duke, talk about what you want to hear from these management teams there early november.

I think that goes directly to what we are talking about is how are you going to serve electricity and man growth? The union serves what we call data center. Allies are raised 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 gona see the hyper growth on data signs in other original. But IT is going to be interesting there from the year over the next several quarters about how they serve demand for data signers, how they might be able to help other you they serve that demand.

Can they continue serving demand as these data signers want more clean energy? So the minion right now, building on the largest offshore wind projects in the world, in part because their data on our customers want clean energy, are also one of the large solar developers. You see a lot of wind and solar coming in the the Virginia and that surrounding area.

It's becoming very expensive as we've seen from some of the Price signals here in the last ever want to say watch the minion due is one of those. If you put due in southern nice or several these mids of last minute atlantic utilities, I think that's where you're going to see some this new data center. great. So we're going to hear from them about how they plan to serve brand new large load and what energy .

companies does morning star consider under value at this time?

No surprise. We do think there is sever really good values where the designers are coming in. Again, electricity demand grow souls.

A lot of problems for utility that creates earnings growth, that creates diverting growth. IT could improve, regulate relationships. IT could lower customer bills depending on how the calculations go.

A lot of things are still unknown that others a lot of discussion about how do you charge data centers? If utilities go out and spend billions of dollars to hold up a data center, who pays for that? Does the customer home pay for that? Does another business pay for that? Or should the day does not pay for IT itself.

So there's a lot of that going on. I think if you look at four names we're talking about, nice source. North was in Diana.

So I mentioned that a lot of growth there. We think they could get up to even eight percent earnings, dividing growth for a decade. They just extended their growth outlook and more potential is coming due.

Energy is one also lot of growth there from just core electricity demand growth as well as data in our opportunity. W V C energies open wisconsin again. Another data center story, southwest with south east wisconsin, is becoming a data center hub here.

Microsoft also getting into data signers in that area of the country. And then average is an interesting name that we haven't talked about a lot. But based in kansas and missouri, go figure.

They also have a date designer that could be coming in to that area. And there are seeing surprisingly strong core commercial, industrial and residential growth there. If they can improve the regular or environment in measuring kansas, there's a lot of growth outside terms of earnings and dividends.

Well, travel, thank you for coming to the task today and explaining the latest on data centers and energy demands for them.

Thanks every that wraps up this .

week's up is so thanks for listening and making this show part of your day. The investment in size team asked that you give our podcast five stars to help others find the work we're producing for you. Thanks to seeing your video producer, jack bank son.

And I still see a multi media ever, just a bubble. Am I va. Hampton lee, multi media editor, morning star, take here.

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