Leverage sub 1

If you are a retiree and need a predictable stream of income from your investment portfolio to cover basic living expenses, you should probably be invested predominantly in investment-grade bonds from highly-rated corporations and the Treasury. If you’re willing to take a little more risk than that in order to increase your expected return, usually you do it by investing more and more in the stock market. Unfortunately, for levels of portfolio risk above what is usually considered the very conservative end of the spectrum, there are diminishing returns in the risk/return tradeoff: as you increase the aggressiveness of your investments and take on more and more risk, you get rewarded with less and less additional return. This is a natural consequence of concentrating your portfolio more and more into stocks, which tend to be volatile and highly correlated.

There is another way of increasing your portfolio’s expected return, a way that allows for a proportional tradeoff between risk and return, a way that maintains diversification among all major asset classes without undue concentration risk, a way that is taught to undergraduate finance students all over the world: leverage.

Leverage

Leverage is the use of borrowed funds for investment purposes in order to (hopefully!) earn a higher return than would otherwise be possible. Banks, insurance companies, and other financial intermediaries and major corporations use leverage all the time, borrowing from depositors or issuing bonds in the credit markets and using the proceeds to invest in business opportunities they believe will more than make up for the interest payments on their debts. Homeowners often use a great deal of leverage when buying a house, often borrowing 80% or more against the value of the property. The world economy as we know it would not function without leverage.

Yet, most individual investors and financial advisors avoid leverage in their investment portfolios completely. This seems to be a result of ignorance or irrational aversion. The common perception is that using leverage is dangerous and only short-term speculators, not patient, long-term investors, use it. But basic finance theory shows that by employing moderate leverage to a conservatively diversified portfolio, the return and risk characteristics can be improved over even a conventional moderate portfolio of 60% stocks, 40% bonds, much less an aggressive, all-stock portfolio.

Empirical research suggests using moderate leverage can boost returns 3 percentage points or more over the long run, for a given risk tolerance. We employ leverage with clients for whom it is appropriate and continuously monitor our portfolios to ensure they maintain adequate margin and liquidity requirements and are not exposed to any unforeseen risks.

References

Applying leverage to a diversified portfolio can greatly increase return while maintaining moderate risk: “Leverage Aversion and Risk Parity” by Asness, Frazzini, and Pedersen (2012).