In an increasingly challenging market environment, particularly with respect to investment returns, it is important for asset managers to consider all the tools at our disposal. Total portfolio leverage is one of these tools.
Leverage is most often thought of in terms of the risk that it adds to a portfolio. However, the properties it brings to a portfolio go beyond this. In this note we highlight how, when used judiciously, total portfolio leverage can be an attractive alternative to other methods when trying to achieve a required return on assets in our portfolios.
What is Total Portfolio Leverage?
On some level, most investments utilize leverage. Public and private equities incorporate it through the corporate debt that is inherent in the capital structure of most companies. Real estate and infrastructure are often financed through combinations of debt and equity.
What these forms of leverage have in common is that they are non-recourse beyond the individual investment. As a result, understanding the risk and return implications is best done by analyzing the individual characteristics of each asset in the portfolio.
Total portfolio leverage, on the other hand, is different. It refers to leverage applied to the total portfolio rather than an individual asset. As a result, understanding its implications on expected returns and risks can only be done by looking at the behaviour of the total portfolio through different market conditions.
How to implement Total Portfolio Leverage
There are many ways that total portfolio leverage can be implemented.
One way is through use of financial instruments such as futures, forwards, and swaps. These instruments can provide market exposure greater than the amount of capital invested, thereby generating leverage.
Another is through transactions such as issuance of bonds and commercial paper, or through the use of repurchase agreements. These transactions provide a source of cash that can then be invested in other assets. Bonds and commercial paper do it by simply borrowing. Repurchase agreements, or repos, take a slightly different approach whereby an asset (e.g., a government bond) is simultaneously sold to a counterparty with immediate settlement and bought back, at a slightly higher price, from that same counterparty but with settlement delayed until 3 or more months into the future. This provides cash that can be invested immediately while maintaining the original market exposure to the asset.
Which of these approaches is appropriate in given circumstances will depend on various factors including the implementation costs, liquidity, resulting tracking error, as well as other applicable constraints.
In the current market environment, repos are one of the more cost-effective approaches to achieving total portfolio leverage for most institutional investors.
Doesn’t Leverage Simply Increase Risk?
Much of the focus on leverage relates to the amount of risk it adds to the overall portfolio. However, an equally important characteristic of leverage is that it adds to expected returns. As such, leverage can be a useful tool, especially considering some of real-world realities faced by portfolio managers.
Institutional investors spend a lot of time thinking about their asset mix, the role different assets play in their portfolios, and how to optimize their market exposures to best meet their objectives. They also, by necessity, operate within constraints. Some of these constraints are risk based (e.g., keeping contribution or funded status volatility below a certain threshold). Others are return based (e.g., keeping expected returns at a level where the plan is sustainable).
Often, the biggest constraint is the simple reality that the amount of assets available for investment is limited. This inevitably results in the need to make compromises. Every dollar of assets that is invested in a return-generating portion of the portfolio means that there is a dollar less to invest in the portion of the portfolio designed to provide downside protection, diversification, or to offset other risks (e.g., interest sensitivity of plan liabilities).
Total portfolio leverage can mitigate these constraints. It increases the total amount of assets that is available for investment and by doing so, it allows investors to better meet their objectives. As an example, this could allow the investor to build a portfolio which, when levered, is expected to generate superior risk adjusted returns.
Because of this, our general view is that total portfolio leverage can sometimes be a better way to achieve investment objectives than many of the alternatives, such as adding more risk assets to the portfolio; adding more illiquid assets to the portfolio; reducing diversification / pursuing more “alpha” within asset classes; or making a large bet on specific asset classes. Perhaps it is not surprising that large pension plans and other institutional investors have been using total portfolio leverage as part of their investment strategy for decades.
Having said the above, the use of leverage needs to be considered carefully, as it introduces certain risk into the portfolio.
If the cost of leverage exceeds the returns of the assets into which borrowed funds are invested, it will detract value. This will happen in any period the portfolio assets earn negative returns.
During times of market crises, the sources of financing can dry up (e.g., the commercial paper market or the repo market seizing up) and borrowing costs can increase significantly over a short period of time. In either case, investors can be forced to sell assets at depressed values to meet their obligations – which compounds losses and needs to be avoided. As a result, liquidity management becomes even more critical, especially for investors that are already cashflow negative (e.g., where they pay out more to beneficiaries each year than they receive in new contributions).
All that to say, we are under no illusion that leverage is always the right approach. It increases certain risks but, if used judiciously in certain contexts it can be beneficial and improve the overall characteristics of an investment portfolio.