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Leverage Edge

Better investing through leverage.

Samuel Lee, 07/17/2013

In the years before 2007, there were two common attitudes toward fast-rising debt levels: complacency or greed. Many central bankers mistook what was really a symptom of illness as a sign of innovative fever, a new-era financial system that could slice, dice, and disperse risk to those who could best bear it. Banks, hedge funds, and households were borrowing oodles of money to bet that housing prices nationwide would never fall much. Lenders tried to eke out extra yield by investing in complex mortgage-related securities, and in doing implicitly made the same bet. Perhaps you remember what happened when house prices did fall. Unsurprisingly, many investors, brutalized by the financial crisis, see debt as an unmitigated bad thing.

It is not, and it never was. Investors are acting like a hungover frat boy who swears off alcohol forever after binge-drinking the night before. Like alcohol, leverage, in moderation, can make life a lot more pleasant, with few ill effects.

It's difficult to make a good asset-class-based portfolio without resorting to leverage of some form. By "good," I mean a portfolio that has both high returns and low risk. Phenomenally talented investors can produce results without leverage through brilliant security selection, but we mortals constrained to index funds cannot. This may seem odd. Leverage, after all, is supposed to make portfolios riskier--how could it reduce risk?

Start with the fact that the assets with the best risk-adjusted returns often have fairly low volatility. The most common measure of risk-adjusted return is the venerable Sharpe ratio (named after inventor and Nobel Prize winner William Sharpe):

S = (R – Rf) / σ,

where R is the annualized asset return, Rf is the annualized risk-free rate of return, and σ is the annualized standard deviation of R (more technically, R minus Rf). The ratio measures the excess return for each unit of risk borne.

In Exhibit 1, I've computed the Sharpe ratio of corporate bonds with different credit quality. As quality goes down (and yield up), the Sharpe ratio declines.

Samuel Lee is an ETF Analyst with Morningstar.
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