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The Problem With Leverage in a Portfolio

Barry Ritholtz has a new article on Bloomberg discussing San Diego County’s firing of a risk parity firm that used to manage part of its pension.  Risk parity strategies often engage in using leverage.  Cliff Asness, who runs AQR, a firm implementing risk parity approaches (among others), hated Barry’s piece and called it “facile” “innuendo”.  He then referred to a piece explaining why he likes leverage in a portfolio at times.  So, who’s right?

Leverage is a bit like steroids. Steroids are neither good nor bad. They tend to magnify the effect of something and that can be good or bad depending on how it’s used.  If you use steroids in specific targeted ways they can be an effective medical treatment. Likewise, if you abuse them they can be a destructive and unnecessary supplement.¹  Leverage is essentially the same thing.  It will magnify the effect of a portfolio’s outcomes.  There are very reckless ways to do this and very safe ways to use leverage. But one thing is almost always undeniable – leverage will cost you.  And that’s the kicker.

Borrowing money you don’t have is essentially a form of renting. And renters charge fees.  The cost of leverage in a portfolio typically depends on the fee that brokers charge. This is usually a spread over LIBOR.  This allows clients to fund their long positions and the broker pays some spread below LIBOR for cash deposited by the clients as collateral for short positions.  The cost of the leverage will vary depending on who the borrower is.²

The inherent difficulty in using leverage is that the fund manager is essentially passing on another cost to the end investor. That is, leverage reduces the real, real return of a portfolio by the cost of the leverage. In the aggregate we know that all managers are generating the market return minus their costs (taxes, fees, etc) so if everyone started using leverage then our returns would be reduced by the cost of the leverage.  And that’s the difficulty of using leverage in a portfolio.

I like the concept of Risk Parity, but it’s hard to justify owning a lot of such a strategy simply because it’s an inherently expensive strategy to manage.  And  in a world that is likely to be a low return world that is potentially just adding another hurdle we don’t need.

¹ – I am not a doctor and I don’t even play one on TV.  

² – This cost will vary on how the leverage is implemented. The cost of many risk parity approaches results from trading in more expensive underlying instruments such as reverse repurchase agreements, futures and swap transactions or certain other derivative instruments. In addition, many institutions are able to obtain this leverage inexpensively, but ultimately pass on the convenience of this exposure to clients in higher management fees.