How Borrowing Costs Affect Hedged Strategy Outperformance
Summary
The document examines whether a strategy that slightly outperforms an index can produce a profitable market-neutral bet by pairing a long position in the strategy with a short position in the index. Its example illustrates how a small return spread translates into a small gain before financing costs, even when the positions have equal starting value. Leverage could magnify that spread in a frictionless setup.
In practice, the cost depends on the broker’s margin terms and available capital. The response says retail investors may face borrowing rates that exceed the spread generated by the example, making the leveraged trade unprofitable. It suggests evaluating the question with explicit assumptions for the margin rate and leverage ratio. The example is illustrative rather than a general formula: actual profitability also depends on the hedge, financing terms, and realized returns, none of which are developed in detail.
Key ideas
- A small return advantage over a benchmark produces only a small unlevered spread in a hedged position.
- Leverage can amplify the spread, but borrowing costs reduce or can erase the gain.
- The financing rate available depends on a trader’s capital and broker agreement.
- Assess profitability by specifying the borrowing rate and leverage ratio alongside expected outperformance.
Tags
Full text
# What does leverage cost? # What does leverage cost? Let's say I've developed a strategy that always outperforms the S&P-500, let call it the "magic strategy". Now I should be golden. All I need is to always have the S&P shorted with the same amount as I have in the magic strategy, and my outcome is bound to be positive. But how much better does my strategy have to be? Let's say that while the S&P returns 10% per year and my strategy returns 11% in the same period, then my set-up return would look like this: - 50% of my money invested in S&P shorts becomes 45.45% of the starting value - 50% of my money in the Magic Strategy becomes 55.5% of the starting value making my collected results 1%. In a world where everything is free, I could just leverage this 1:99 and the result would be 100%, not bad? But what would be the cost of this sort of strategy in the real world? How much do I have to outperform something in order to make a "A outperforms B" sort of bet? When I read papers they often show how this or that approach, outperforms some index -- how much do you need to outperform something to be able to make a hedged bet? ## Answer by glyphard (score 2, accepted) https://quant.stackexchange.com/a/3079 cost of leverage for equity only long/short investing is a function of the margin deal you can negotiate with your broker, if you have a large amount of capital. If you don't have significant capital to start with, then it's likely you'll only be able to get 2x leverage with a loan rate between 4% and 10% (retail reg-t margin rates at most brokers) This would render your strategy unprofitable, since you'd be paying 2% to 5% loan for a portfolio that only generates 2% return. You might get more traction by restating the question as: Assuming a margin rate of X% with a leverage ratio of Y times capital, how much does a strategy have to out perform a hedge portfolio to earn a positive return. (simpler to estimate)
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