Is Levering a Portfolio Ever Worth It?

(July 26, 2013)  -- The decision to lever-making the right one, that is-all comes down to market frictions, three University of California, Berkeley, researchers have concluded. 

Investors and academics alike all-too-often discount the impact of transaction costs on levered asset returns, authors and economists Robert Anderson, Stephen Bianchi, and Lisa Goldberg noted.

Their study compared the performance of three leverage strategies using stock and bond market data from 1921 through 2012, both sourced from the Center for Research in Security Prices. The authors' formula had trading costs falling over time, as transacting a levered portfolio in the 1920s was considerably more labor intensive than in the early twenty-first century. 

The simplest of the three strategies, fixed leverage, operated on momentum, ratcheting up as the asset appreciated and down as it devalued. In a frictionless, fee-free environment, applying the fixed leverage approach to $1 of US treasuries in 1929 would have become $4822 by 2012. Unlevered, that same $1 would have been worth $68.

The second and third strategies adjusted leverage based on volatility targets, with more or less freedom to rebalance. The more flexible of the two volatility strategies would have turned $1 in 1929 into $9301 more than eight decades later.

However, when the researchers introduced transaction costs, these gains fell by factors of up to 2000. Fixed leverage grew the original investment into $209, flexible volatility into $30, while the less supple volatility approach returned $1.41 over the course of 84 years.

The study's back-testing of theoretical, formulaic fixed income leverage was no exact proxy for the practice in real life. Nor, of course, was their transaction fee structure.

Goldberg, Anderson, and Bianchi-all three of them veterans of institutional portfolio research-acknowledged strategies for which leverage does make financial sense amid a frictional market.

Harvesting low-volatility premia or taking advantage of the "low risk anomaly" would typically require leverage. This "is arguably the only rational argument for an investor to use leverage in an investment portfolio composed of publicly traded securities," according to the paper.

The authors made it clear that the study was not an explicit examination of practiced levered bond strategies, risk parity or otherwise. Rather, the prevalence of such strategies made in-depth study of leverage important.

"Even among the most conservative and highly regulated investors such as US public pension funds, the use of levered investment strategies is widespread and growing," Anderson, Bianchi, and Goldberg wrote. "In the period since the financial crisis, strategies such as risk parity that lever holdings of publicly traded securities have emerged as candidates for these investment portfolios."

Another feature of the post-financial crisis environment-extraordinarily low interest rates-has made these strategies vulnerable, they cautioned.

As quantitative easing comes to end, the authors predicted, "the cost of funding a levered strategy will rise dramatically, and historical precedent suggests that the impact may well be amplified by declines in asset prices. These considerations should be incorporated in any decision to lever."

Read Robert Anderson, Stephen Bianchi, and Lisa Goldberg's entire paper here.