From Institutional Investor, Feb. 11, 2014:
Conventional wisdom is against leverage. It reeks of
imprudence. It gets the blame for financial disasters
(sometimes fittingly). Yet the unconventional wisdom here is
that leverage is often both startlingly useful and startlingly
conventional, though it comes with a responsibility to manage
it actively and well.
How is leverage conventional? Well, one of the first things
we learn in finance class is that you don’t search for a
single asset that perfectly fits your risk-return profile.
Instead, you look for the portfolio of assets that offers the
best return for the risk taken (however you measure risk) and
adjust it to your desired risk level by adding leverage or by
delevering, which means keeping some assets in cash. It usually
turns out that allowing some amount of leverage lets you build
a better portfolio than what you can build without any
leverage, without taking on more risk.
This is not a miracle of leverage; rather, it’s a
miracle of diversification that you happen to need leverage to
perform. Imagine the simple case of allocating between stocks
and bonds. Without leverage, if you’re aggressive, you go
with mostly stocks; if conservative, mostly bonds. But therein
is a problem. Both of these portfolios are undiversified. By
first finding the “best” portfolio and then applying
more or less leverage to it, you can set the risk to your taste
while always investing in a diversified portfolio.
Or imagine allocating alternative investments among
long-short market-neutral managers — one trading stocks,
one trading bonds and one trading commodities. They take equal
position sizes, and you believe that for the risk taken they
each have comparable skills. If you allocate equal dollars, you
have mostly commodity risk and virtually no bond risk, as, at
equal dollar sizes, commodities will dominate your returns
(stocks fall in the middle). If instead you balance the risk by
giving a large dollar allocation to the bond manager, a
moderate one to the equity manager and a small one to the
commodities manager, you will have a much more diversified
portfolio and a higher expected return for the risk taken. But
now you will need some mild leverage to get your expected
return back to the level of the equal-dollar portfolio.
Note a commonality to these examples. You are using leverage
not to take on more risk but to raise a better but lower-risk
portfolio to the same expected return.
Now for the caveats. Leverage is a tool....MORE
And if you apply leverage to gearing:
et voilà: LTCM!
