You heard that right! You can use leverage the smart way and reduce risk, all the while keeping the expected returns the same as in an unleveraged portfolio. Leverage has gotten a bad reputation, sometimes for a good reason, think Global Financial Crisis in 2008/9 or the LTCM debacle that almost sank the financial system in 1998. But every force can be used for good or bad, think Star Wars. So how do we change leverage from a Darth Vader to a Luke Skywalker?
To recap, there are several reasons to use leverage:
- The sucker bet. People max out their credit cards to put money into a “sure bet,” a stock recommended by their hair stylist or brother in law. Or they buy levered ETFs, also a bad idea, see our earlier post on the pitfalls. This is the bad form of leverage because you use it to double (or triple) down on an already risky investment. Don’t do it!
- The sucker bet that even the most sophisticated financial experts fall for: Google “LTCM leverage” to find the story of the hedge fund that blew up in 1998. It operated successfully for many years finding minute arbitrage opportunities and traded on those with huge leverage factors. It worked great until, well, until it stopped working and sank LTCM and almost the entire US financial sector over concerns about who LTCM’s counter-parties were. In finance it’s called picking up coins in front of the steamroller. Works most of the time, but sometimes the steamroller is faster.
- One could use leverage to adjust for the effect of marginal taxes on your after-tax returns. If taxes reduce both your expected return and your risk (measured as standard deviation) by the same multiplicative factor of 1-tax rate then why not scale up your portfolio, as we detailed in our Synthetic Roth IRA post where we showed how to generate Roth IRA returns in a taxable account, without the constraints of annual contribution limits.
- Using leverage the smart way to reduce risk. Of course you don’t want to lever up the already risky part of your portfolio (equities). You want lever up your diversifying assets, most notably bonds. Levering up bonds can indeed reduce your overall risk, while keeping the expected return the same as in the unlevered portfolio.
And you guessed it, we don’t want to talk about the Synthetic Roth IRA again and definitely not the sucker bet type of leverage. Let’s look at how one can use leverage to reduce risk.
The finance theory behind this is that one can use the less than perfect correlation between stocks and bonds for diversification. In fact, lately, the correlation between stocks and bonds has been mostly negative (about -0.25 to -0.30 over the last few years), which means you can benefit a great deal from diversification.
Efficient Frontier Analysis in a Stock-Bond-Cash Portfolio
Let’s start with the expected return, expected risk and correlations of the three assets:
An efficient frontier is the scatter-plot of expected risk (x-axis) vs. expected return (y-axis) pairs so that for every expected return target there isn’t another portfolio with lower risk. This is done using no leverage and no shorting. The efficient frontier is easy to compute in a three asset portfolio with two risky assets (stocks and bonds) and one risk-free asset (cash). It simply traces the risk/return profiles of portfolios with x% stocks and 100-x% bonds (and thus zero cash), see blue dots in the chart below. With more assets in the mix it would become slightly more complicated (quadratic constrained optimization) and would require some more programming beyond the capabilities of Excel.
Thanks to diversification between stocks and bonds, our efficient frontier has a parabola shape, twisted to the left. That’s because, for example, a 50%/50% portfolio has exactly the average return of the two assets, but significantly less then the average risk of the two assets.
Side note: Real finance purist that we are we do not consider the lower portion of our blue dots (from 100% Bonds moving in a Northwestern direction up to the turning point) a part of the efficient frontier because that part is transparently inefficient as you can increase expected return while decreasing expected risk when moving to the upper left. But we find it easier to simply plot the entire parabola in Google Sheets, with this caveat attached.
If we draw a tangent line between the cash dot and the efficient frontier we identify the tangency point, marked as the yellow dot. It gives you the highest Sharpe Ratio (excess return over cash per unit of risk). If we could use leverage to scale up this tangency portfolio we’d move to the Northeast along the green dots into an area significantly more attractive than the efficient frontier. The entire purple area is better than the efficient frontier, and of course the path along the green dots is the most attractive risk-return trade-off. It’s better through the force of leverage (which was not allowed in the construction of the efficient frontier).
The calculation of this efficient frontier, as well as the calculation of the tangency portfolio are in the Google sheet posted here, for folks to play around. Try your own parameters and see how the efficient frontier and the tangency line change:
Google Sheets link to Spreadsheet to generate Efficient Frontiers (sheet cannot be edited, but you can download and play around with the parameters)
The tangency portfolio has about 60% bonds and 40% stocks. Notice how the risk is only 6% annualized, but the expected return is quite measly: 3.68% (nominal). Nobody can save for or fund an early retirement with that!!!
Scale up the tangency point to match the expected return of stocks and we start getting somewhere! At 7% return we now have a risk of only 12.31%, instead of 15% in the all-equity portfolio. That’s a sizable reduction in risk, through the power of leverage.
Alternatively, we could scale up the portfolio all the way to match the stock risk (15%) and gather the extra return of 8.45%, 145 basis points better than the stock portfolio.
We also include some other examples:
- An 80/20 portfolio vs. an 80/100 portfolio (80% stocks, 20% bonds, another 80% bonds on margin). You get roughly the same risk with the leverage portfolio but much bigger expected return. Also notice that an 80/20 portfolio has essentially a perfect correlation (0.995) with stocks. That’s unappealing. The 80/100 portfolio has a lower correlation.
- A 60/40 portfolio has pretty measly expected return and also very high correlation with stocks. A 60/100 portfolio juices up the return, with slightly higher risk and much lower stock correlation.
- Note that both the 80/100 and 60/100 portfolio are not on the tangency line, but they are pretty darn close, with a Sharpe Ratio only marginally below the optimal Sharpe Ratio.
Implementing even large degrees of leverage is relatively easy with futures contracts. We wrote briefly about the ins and outs of equity futures investing in our Synthetic Roth IRA post and the mechanics here are similar. Probably the most elegant way to implement a sample portfolio of about 80% equities and 120% bonds would be to hold the entire equity portion in physicals (e.g. Stocks, ETFs, mutual funds) another 18% in bond funds and the remaining 102% bond futures. The 2% leftover cash is more than enough for the margin on Treasury futures.
What happens when we change some of the assumptions?
- Corporate bonds instead of 10Y Treasury bonds: you get higher yield, but also higher correlation with stocks. One would need over 100% of bond exposure (hard to accomplish since there are no corporate bond futures) and another close to 60% stock exposure. To mimic this portfolio one would probably have to hold the bonds as an ETF (slightly under 100%), keep the remaining portfolio cash in cash to be used as margin for equity futures. The reduction in portfolio risk relative to the all stock portfolio is over 18%. 12.25% risk instead of 15%.
- Junk (high-yield) bonds: you further increase the yield, but the correlation is now substantial. 108% target weight in junk bonds would be hard to accomplish, but one could get close by holding almost the entire portfolio in bond ETFs and the equity exposure in stock futures.
- Treasuries, but assume zero correlation instead of negative correlation. This is still easy to implement: keep one asset as physicals the other as futures on margin. Reduction in expected risk is much lower though, less than 1/10.
- Higher cash expected returns: Still very high bond weight, reduction in expected risk also less than 1/10.
Limitations/What can go wrong?
- All the other drawbacks of trading futures apply here as well, and we outlined those already in our Synthetic Roth IRA post. Those include the large size of single futures contracts ($130,000+ for the current 10 year future, $100,000 for S&P500 e-mini futures), the need to “roll” the contracts once a quarter, etc.
- The negative correlation between stocks and bonds could break down. An inflation shock a la 1974 would drag down both bonds and stocks. What is the likelihood of that? OPEC has lost its bite and US central bank policy has gained a lot credibility and transparency since then, so we doubt this is really in the cards going forward.
- Parameters for the tangency point and thus the desired portfolio will change (e.g., Treasury Yields!!!). When assumptions change we have to recalculate the weights and adjust the portfolio.