Quick Bites | Danger of Excessive Leverage in Markets

Warren Buffett famously warned that leverage is an addictive “double-edged sword” that turns market volatility into permanent capital destruction. He points out that when a streak of positive gains is multiplied by even a single zero, the entire fortune evaporates.

Source: Forbes

Buffett’s views on the danger of excessive leverage include:

•             The Ignorance Factor: “When you combine ignorance and leverage, you get some pretty interesting results,” meaning that borrowing amplifies the damage done by investors who don’t fully understand the risks they are taking.

•             The “Smart Person” Trap: In his 2010 letter to Berkshire Hathaway shareholders, Buffett highlighted that leverage is the only way a smart person gets “clobbered”. Because leverage magnifies gains, it creates an illusion of cleverness, leading investors to take increasingly reckless risks.

•             Illiquidity and Forced Selling: Borrowing imposes strict contractual obligations. During market panics, overleveraged investors face margin calls, forcing them to sell assets at distressed prices when they should be looking to buy.

•             Asymmetric Risk: Buffett summarizes his view on retail leverage simply: “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.”

I agree with Warren Buffett. It usually pays to agree with Buffett, whose track record over decades is virtually unparalleled. The US market has achieved staggering returns over the past 3 years, rising to record levels. Over the past 12 months, the US S&P500 index has risen 20%, Nasdaq has risen 33%, and the Dow Jones is up 17%. By comparison, the Australian ASX 200 is up only a meagre 2.5%. Yet all markets are succumbing to excessive exuberance, with the AI theme yet to deliver hard cold cash returns and many market participants over-leveraged.

Without doubt, artificial intelligence is technologically transformational. But it does not follow that investment returns are guaranteed. The surging numbers of retail investors in the sharemarket has heightened the risk of a much bigger economic fallout from a correction that threatens financial stability.

The Bank of International Settlements – often regarded as the central bank for central banks – has warned of the risks of highly leveraged hedge funds playing noy only in the equity markets but in the bond markets too, along with debt-fuelled spending on artificial intelligence.

In the bank’s 133-page annual economic report, it warns that a market correction – where an index falls 10% from its recent peak – risks triggering an economic downturn because of the growing retail investor exposure to equity markets. This is particularly evident in the world’s largest economy where more American household net worth is held in the sharemarket than before the dotcom bubble.

Investors have never been more eager to ratchet up their stock returns through margin loans and funds that amplify gains and losses. 

US margin debt, or what investors borrow from their brokerages to buy securities, rose 54% to a record $1.4 trillion in May from a year earlier, according to FINRA data. Meanwhile, high-risk leveraged exchange-traded funds that produce double or triple the daily move of underlying stocks are growing rapidly, as is trading in options tied to them.

The risks surfaced last week in South Korea, a market dominated by highflying semiconductor stocks and rife with investors eager to pile on leverage. Korean stocks gyrated, triggering circuit-breakers meant to stop losses on the way down.

“I’m fearful that we’re building unintended leverage that isn’t fully understood,” said Mark Hackett, market strategist for Nationwide. “You’ve got people with a lottery mentality using margin to buy options on levered ETFs. That’s three or four layers.”

Buyers ranging from hedge funds to teenagers on Robinhood have poured money into leveraged ETFs this year, helping to nearly double the assets in these funds to a record $220 billion between March 30 and June 3, according to FactSet.

The risks of buying leveraged funds are well-advertised: a 30% drawdown in the underlying stock can turn into a 90% wipeout for the fund. But Wall Street sees a broader problem appearing: these funds, along with other forms of leverage, can also affect how the individual stocks behave. The recent action in South Korea offers a sneak peek at the risks.

In a bid to keep pace with the flow of new money, leveraged funds have bought some $300 billion in derivatives linked to single stocks and indexes since the end of March, Barclays analysts estimate.

Those purchases have in turn spurred demand for underlying shares from market makers, which buy stocks to hedge their exposure to the derivative contracts they write. 

That has contributed to the sharp gains in the market this year, but when stocks fall, leveraged funds lose assets. That forces them to reduce exposure to the shares they track, which in turn threatens to pull down stock prices even more. There is a danger that this cycle can quickly spiral into heavy losses.

“That’s a somewhat terrifying figure to contend with should it need to be unwound in a short period of time,” Alexander Altmann, head of equities strategies at Barclays. “This is without a doubt the largest nondiscretionary driver of risk at the moment.”

South Korea’s top financial regulator said earlier last week that he regretted not blocking the launch of leveraged single-stock funds. “These are high-risk products, and it seems like about 92% of holders are retail investors,” Financial Supervisor Lee Chan-Jin said. “Despite consumer warnings, trading hasn’t cooled.”

Source: Bloomberg

There is some healthy scepticism creeping into the Mag 7 and IT sector, involving rotation into other less expensive and under-loved areas of the market over the last few weeks.

Source: Deutsche Bank

The dangers of foolish money following fads and with little understanding of how hundreds of billions of dollars of investment capex will provide real returns continues unabated. While the ASX is less exposed to some of these excessive leverage traps, if markets in the US turn sour, I’m afraid there will be nowhere to hide.

See below two charts from Morgan Stanley that show CME’s “Adjusted Interest Rate” futures on the S&P 500’s total return index. Basically, these show the extra cost of leveraged investments in US stocks above benchmark interest rates. And as you can see, things have gotten rather frightening of late. You have been warned – don’t overdo the exuberance and be wary of buying too much on the credit card.

Source: Financial Times, 30 June 2026