Employing Leverage
The common denominator of some of the most innovative investment
strategies being developed to meet changing investor objectives is leverage.
Leverage, at its simplest, can be defined as attaining gross market exposure greater than what could be achieved if investing capital through traditional cash instruments. The key benefit of using leverage is to effectively manage portfolio risk while striving for enhanced returns.
As an investment tool, however, leverage provokes strong responses, both positive and negative. Some investors associate leverage with high-risk investment strategies or with investment products that heighten exposure to risk. The accuracy of that assessment is debatable, but there is no denying that leverage does increase exposure to risk, just as it can magnify potential returns.
Investment strategies that employ leverage have grown in popularity during the past few years. One catalyst is that institutional investors, such as pension funds, have become more open to adopting innovative and somewhat riskier strategies in order to meet growing liabilities.
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“Leverage can be achieved in many forms, with common approaches including outright borrowing of funds or using derivative instruments to obtain notional exposure.”
— John Krieg, CFA, director, investment product management at Northern Trust
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“Leverage can be achieved in many forms, with common approaches including outright borrowing of funds or using derivative instruments to obtain notional exposure,” says John Krieg, CFA, director, investment product management at Northern Trust. Examples of strategies that employ leverage include portable alpha, liability driven investing (LDI) and active extension 130/30 (also known as short extension or long/short). These investment strategies vary in terms of the potential returns and risks involved and how leverage can be used effectively while managing risk.
An innovative and efficient method to help achieve a desired investment outcome is to employ a portable alpha technique. Portable alpha relies on separating the return attributable to a manager’s skill from the return derived simply through passive market exposure. The alpha in theory can be transported to another market index or strategy, one that is better aligned to the investor’s overall investment objective.
Leverage is employed in many portable alpha portfolios. These strategies are implemented through the use of derivatives such as futures or swaps, resulting in the portfolio’s gross market exposure exceeding 100%.
Assume a pension fund holds only bonds in order to match its liabilities. Maintaining that fixed-income exposure (beta) through derivatives would free up cash, which could be invested in another asset class or strategy in a quest for more attractive returns. If the pension plan sponsor wanted to capture the return of a particular active small-cap manager, the plan sponsor could invest the freed up cash with that manager and short the Russell 2000 Index. Shorting the index should remove any net exposure to small-cap stocks and isolate the alpha created by the selected manager. The small-cap alpha could then be ported onto the beta exposure captured through the fixed-income derivative, potentially resulting in a total portfolio return in excess of the liability.
Although this strategy could expose the portfolio to greater volatility, seeking alpha sources from an uncorrelated asset class or geographic region having a low or negative correlation with the beta could mitigate the risk. In addition, across an entire portfolio, this might create less volatility if the entire risk and return generated by the portable alpha strategy were uncorrelated with the remainder of the portfolio.
Liability driven investing seeks to better manage the risk-return trade-off between a pension plan’s assets and its liabilities. LDI strategies often begin with reducing the interest rate and asset class mismatch between assets and liabilities.
Non-leveraged approaches, such as lengthening bond portfolio duration or fully immunizing pension liabilities, are fine first steps. Leverage does offer an advantage in that it can allow the plan to maintain its desired asset allocation — 60% stocks, 40% bonds, for example — rather than converting to a portfolio consisting entirely of long-term bonds. This would enable the pension plan to benefit from the potentially higher returns offered by a diversified portfolio.
The use of leverage in an LDI strategy frees up cash to be invested in higher return-generating strategies. For example, by using an overlay of interest rate swaps, the plan can manage its duration profile better, reducing the tracking error between its assets and liabilities.
Active extension strategies, which could entail 120/20 or other degrees of long/short exposure in addition to 130/30, involve a more straightforward application of leverage. “In addition to a fully long core exposure to equities, the strategy allows for a regulated degree of short exposure, matched by a long extension of the same percentage,” says Jeremy Baskin, head of active global quantitative management at Northern Trust.
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“In addition to a fully long core exposure to equities, the strategy allows for a regulated degree of short exposure, matched by a long extension of the same percentage.”
— Jeremy Baskin, head of active global quantitative management at Northern Trust
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The “30” in 130/30 refers to an additional 30% of the basic stock investment that could be sold short on selected stocks which are expected to underperform the long positions. The proceeds from the short sales would effectively fund an additional 30% in long positions. This leverage enables investment managers to further capitalize on their positive and negative insights on individual securities. The use of leverage has the potential to magnify returns — as well as risk — by adding exposure to potential alpha generation on both the long and short sides.
To illustrate this, let’s assume the long portfolio generates outperformance of 5% relative to its benchmark. If the manager demonstrates equivalent skill with the 30% invested short and the additional 30% invested long, an extra 3% of outperformance would be generated. In addition, because the strategy does not leverage an investor’s exposure to the overall market, the beta on the portfolio is about one.
There’s no question that using any technique to obtain leverage, such as short selling or derivatives, opens the door to increased risk. “Different techniques employed to obtain leverage will carry their own kind of risk,” Baskin says. “The key is to recognize that risk and manage it effectively.”
For example, short selling is used to provide basic leverage or to extend the 130/30 active extension strategy. It exposes investors to the prospect of theoretically unlimited losses if a shorted stock should rise significantly, rather than fall in value as expected. With 130/30, there are built-in limits placed on the long and short positions overall, as well as maximum exposures to each industry and each individual security.
“Taking care to limit the magnitude of the leverage to a reasonable level is important,” Krieg says. “Even more important is understanding how volatility and correlation play into the equation.”
Leverage is a powerful investment tool. When employed strategically, intelligently and judiciously, it can enhance returns and be the difference between achieving critical investment goals or falling short. Care should always be taken to maintain risk exposure at manageable levels and to take appropriate measures to manage the risk-return trade-off.
The accompanying chart compares several actively managed equity strategies, each with its own distinct investment process and philosophy. Product A follows a traditional active long-only strategy. Product B allows short positions of up to 30% of portfolio assets and uses those sales to increase the long positions (up to 130%). Product C is a market-neutral capability in which offsetting long and short positions provide returns, but result in a net market exposure near zero.
While each strategy has “net” equity market exposure (long exposure minus short exposure) of 100% or less, products B and C have the potential for increased returns and risk through leverage. Net exposure, however, only provides a partial view of the risk profile of an investment strategy. A review and thorough understanding of the gross market exposure, the maximum allowed leverage and what is being levered is critical to a more robust evaluation of a strategy’s risk and return potential.
Source: Northern Trust
Notes:
1) Gross exposure represents the sum of long and short exposure.
2) Represents net long market exposure.
3) Strategy takes offsetting long and short market positions resulting in a market beta near zero.
Leverage is a highly flexible investment tool that can be dialed up or down like a thermostat to suit an investor’s motivation, objectives or confidence in an investment manager.
What is the optimal leverage ratio for an equity strategy with limited shorting? Currently, the active extension strategy popularly known as 130/30 is receiving considerable investor interest. This strategy builds on a 100% long base and offsets limited short positions with long positions. The result is a gross market exposure of 160% — 100% long base plus 30% short plus 30% long — and a 100% long net exposure. But 130/30 is not a magic formula. This same approach could be taken with any leverage ratio — for example, 120/20, 140/40 or 150/50.
Factors influencing an optimal leverage ratio include:
- The investor’s risk tolerance — The more risk averse the investor, the less likely shorting will be considered.
- The specific risk in a security — The lower the risk, the more attractive the short.
- Frictional costs — The higher the frictional cost of a short, the less attractive the short.
- The weight of a security in the benchmark — The smaller the weight, the more likely the short. This is because it is difficult to express a negative sentiment on a stock with a small weighting without taking a short position.
- Benchmark concentration — Highly concentrated benchmarks will tend to have more short positions. Short positions can be added with less impact on the overall residual risk of the portfolio since so much of the portfolio risk is embedded in very few names.
With these variables taken into consideration the optimal leverage ratio will be the one that maximizes risk-adjusted returns.
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