Leverage Edge

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.

This is a near-universal pattern within asset classes: Higher volatility usually accompanies lower risk-adjusted return.

In theory, if you identify a high-risk-adjusted-return asset class, you can lever up that asset's absolute return to something more to your liking. Few investors do this for fear of blowing themselves up. Mutual funds can only borrow money up to the point where each borrowed dollar must be backed by three dollars in assets. Even then, most mutual funds choose not to borrow except in extraordinary circumstances. Many pension funds also choose not to apply leverage.

Modern Portfolio Theory prescribes that investors should first find the highest Sharpe ratio portfolio possible (the tangency portfolio), then leverage or deleverage it to achieve their return targets.

Of course, few investors do this. In order to achieve their return targets, most investors simply choose to own more risky assets. An aggressive investor is supposed to own more stocks and lower-quality bonds; a more conservative investor is supposed to do the opposite.

As a result, low-volatility investments tend to offer attractive risk-adjusted returns. There just aren't enough investors out there willing and able to short-sell high-volatility assets and buy low-volatility assets.

So what? No one reading this is going to go out and borrow money to invest in their portfolio (I hope!). However, investors can exploit leverage aversion by investing in funds that can safely lever up their portfolios.

​Before we can talk about "safe" leverage, we need to talk about what makes leverage dangerous. It's actually not investing in something that goes bust. Most leveraged investors are aware of the danger and therefore tend to apply leverage to sure bets. What kills them is when they need to post collateral (that is, meet margin calls) at inopportune times, and when they can’t, they need to liquidate their positions at fire-sale prices.

In the late '90s, Long-Term Capital Management used a veritable mountain of borrowed money to juice many different "sure" bets. But when financial contagion infected Asia in 1997, and Russia devalued the ruble and defaulted on its debt in August 1998, LTCM's positions moved against it, and the hedge fund found that its finely balanced portfolio, a labyrinthine construct of thousands of offsetting positions in all variety of markets, was knocked slightly off its fulcrum, leading to unexpectedly large losses. Sensing blood, traders took advantage of LTCM's distress by pushing prices in the opposite direction of the fund's bets, until LTCM was near insolvent and had to be bailed out by a consortium of banks. Ultimately, many of LTCM's bets ended up being profitable. If LTCM didn't have to meet margin calls, its partners would still be billionaires (assuming they didn't blow themselves up later on).

Other than cost, leverage is distinguished by its term and whether it's collateralized (backed by the borrower's assets). Hedge funds tend to borrow with daily financing that must be backed by collateral. Unfortunately, such loans are most likely to be withdrawn when the borrower needs it the most, such as during, say, a financial crisis. In late 2008, many funds pursuing generally safe arbitrage strategies, such as merger and convertible arbitrage, had to liquidate their positions at the same time to meet margin calls. This depressed the prices of their positions, which in turn spurred more margin calls.

The poster boy for leverage done right is none other than Warren Buffett. Yes, the man who said, "A long, long time ago a friend said to me about leverage, 'If you're smart you don't need it, and if you're dumb you got no business using it.' " He makes extensive use of a special kind of leverage, the prepaid premiums, or "float," from  Berkshire Hathaway's (BRK.B) insurance operations. Float can never be called away at the whim of a nervous counterparty. Even better, the timing of the payouts is unrelated to market conditions, so Berkshire doesn't have to stump up a mountain of cash just as the markets are going to hell in a handbasket.

Float is so valuable that many insurance companies will write policies expected to lose money overall simply for the privilege of getting their hands on it. The firms turn a profit as long as the investments they make with their float earn more than the losses arising from insurance claims. If you maintain rigorous underwriting standards, as Berkshire's operations do, float can be very cheap. If you turn an underwriting profit, the float's cost is negative--you're being paid to borrow money.

Buffett is quite the fan of free leverage. Another example was when he wrote put options on a variety of broad indexes. For large up-front lump-sum payments, he insured the puts' owners against long-term losses. These weren't your average puts. They, on average, expired 10 or more years out, and most importantly, had minimal collateral requirements and could only be exercised at expiry.

What has the maestro done with all this leverage? Invest in high-quality, low-volatility stocks and bonds. In short, high-quality leverage is cheap, doesn't require much collateral, and isn't subject to big margin calls at bad times. Obtaining it is a big edge and a big reason I like and invest in Berkshire Hathaway.

​Edge
I think investors underappreciate good leverage. In the eyes of many, leverage is leverage, and it's bad. I agree that most forms of leverage are bad and that many leveraged investors are figuratively driving cars with a knife aimed at their hearts attached to the steering wheel. However, there are firms not named Berkshire Hathaway that can use leverage intelligently, and PIMCO is one of them.

PIMCO is a sophisticated user of leverage, obtaining it through swaps, futures, options, reverse repurchase agreements, and direct borrowings. Although PIMCO obtains favorable financing terms because of its built-up infrastructure and size, much of its edge is analytical. It has a Minskyan view of the world: Rising systemic leverage begets growth, optimism, and stability, begetting even more leverage, all the while making the inevitable unwinding of leverage more violent. An appreciation of Hyman Minsky's financial instability hypothesis allowed the firm to avoid taking on stupid risks before the financial crisis.

Leveraging PIMCO
How can one benefit from PIMCO's leverage edge? An indirect way is to invest in PIMCO's Total Return strategy, which makes full use of leverage to make lots of spread bets. A more direct route is PIMCO's IndexPLUS funds. The funds use total return swaps, which require only a modest outlay of collateral, to obtain economic exposure to their target equity indexes and invest the rest of their assets in a clone of PIMCO Total Return. For each $1 of investor capital, the funds offer $2 of economic exposure ($1 in the index and $1 in Total Return), creating interesting portfolio construction opportunities.

The IndexPLUS funds can potentially be risk-reducing to a portfolio if 1) PIMCO's Total Return strategy produces positive returns and 2) those returns are relatively uncorrelated to the rest of the portfolio. Consider two portfolios, each rebalanced monthly. One is split evenly between  PowerShares FTSE RAFI US 1000 (PRF) and  PIMCO Total Return (PTTRX). The other is split evenly between  PIMCO Fundamental IndexPLUS (PXTIX) (which uses swaps to track a slightly modified version of the RAFI US 1000) and PIMCO Total Return. The only big difference between them is that one has twice the economic exposure to PIMCO Total Return. Here are their performance records, from January 2006 to May 2013.

Surprisingly, adding 50% leverage only boosted volatility by little over a percentage point while boosting return by 2.37 percentage points. What about risk reduction? Because the leveraged strategy's Sharpe ratio is higher, it can be deleveraged with cash to a lower volatility and still remain higher-returning than the unleveraged strategy.

This little bit of magic is the power of diversification. Over the period I looked at, PIMCO's Total Return strategy earned positive returns that were largely uncorrelated to the RAFI US 1000's. Assuming these conditions hold in the future (a big if!), the IndexPLUS funds' Total Return exposure can enhance a portfolio's risk-adjusted return.

Aside from the portfolio benefits, the leveraged funds create a tax arbitrage opportunity. Stuffing your IRA or 401(k) with one of these funds effectively doubles your tax-sheltered dollars. You'd want to keep the funds tax-sheltered anyway because they throw off a lot of income.

The institutional share classes can be a pain to invest in, requiring various tricks to get around the high minimums. And you are taking on a lot of PIMCO-specific risk. And they are a tad expensive. However, on balance, I think the funds are worth it.

Bad Leverage
I point to the PIMCO funds because I don't think there are many high-quality sources of leverage for individual investors, other than the 30-year fixed-rate mortgage, which is still a steal at 4.5%. The leverage accessible to individual investors is almost invariably the bad kind: margin loans, leveraged exchange-traded products, high-beta stocks, deep out-of-the-money options, and the like. If you're buying something because it offers you leverage, chances are it's a bad idea.

A version of this article appeared in the June 2013 issue of Morningstar ETFInvestor.

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