“Shrewd” and “prudent” use of leverage should aid a portfolio’s returns without the addition of large amounts of risk, according to AQR founder and principal Cliff Asness.
Writing for Business Insider, Asness argued that applying leverage to an investment portfolio can increase the benefits of diversification.
“Used shrewdly, leverage is your pal, not the bugaboo that conventional wisdom paints it to be.” —Cliff Asness, AQR“One of the first things we learn in finance class is that you don’t search for a single asset that perfectly fits your risk-return profile,” he wrote. “Instead, you look for the portfolio of assets that offers the best return for the risk taken, and adjust it to your desired risk level by adding leverage or by delevering, which means keeping some assets in cash. It usually turns out that allowing some amount of leverage lets you build a better portfolio than what you can build without any leverage, without taking on more risk.”
Asness gave the example of a portfolio split between equity, fixed income, and commodities. Allocating a third of the portfolio to each asset class would exaggerate the commodity risk hugely, but tilting towards bonds with a small allocation to commodities would give “a much more diversified portfolio and a higher expected return for the risk taken,” he said.
“Now you will need some mild leverage to get your expected return back to the level of the equal-dollar portfolio,” Asness added. “You are using leverage not to take on more risk but to raise a better—but lower-risk—portfolio to the same level of risk.”
Borrowing money to boost returns on asset classes is integral to risk parity strategies such as those marketed by AQR. However, in the wake of the global financial crisis some investors have baulked at the perceived risks of increasing exposure artificially: In California, the San Diego County Employees Retirement Association’s board of trustees cited the leverage used in risk parity allocations as one of the reasons to curtail its contract with outsourced CIO Salient Partners.
“Leverage is a tool,” AQR’s Asness wrote. “Like any tool, it can be used poorly and cause harm. Leverage demands that you act in specific, prudent ways.”
Asness urged investors to apply leverage only in moderation and to liquid assets, as “the wrong form of financing plus illiquid assets is what we call, with only some hyperbole, the death combination.” A drawdown control mechanism was also important to mitigate the risk of leverage exaggerating the downside as well as the upside of any investment.
“Used shrewdly—to diversify, not simply to take on more risk—leverage is your pal, not the bugaboo that conventional wisdom paints it to be, we believe,” Asness added.
Related Content: 2014 Risk Parity Investment Survey