For the standard example of the latter, imagine having invested $100 in equities. If instead of buying $100 worth of stock one buys equity index futures, which only require approximately 5% initial margin, that person could obtain an exposure of $2,000 for the initial $100 deposit. This position is both highly levered and very risky: a 5% rise in the value of my portfolio would double the money; a 5% dip would wipe it out.
RISK REDUCTION
This kind of risk is straightforward and well understood by institutional investors. It is the other end of the spectrum that is clouded with some confusion. Institutional investors can look at examples in which the use of leverage can reduce overall risk.
The simplest illustration is a currency hedge. Suppose one has a U.S.-dollar denominated bond, but does not want the currency risk and so hedges the exposure. This strategy uses leverage, as one is selling U.S. dollars forward, and could, theoretically, lose all of the investment in the bond while also losing money on the currency position. But few people would call this strategy risky because both of these risks are well understood: the risk mitigated by the currency hedge far outweighs the risk added through the introduction of leverage.
Similarly, consider the following use of a synthetic portfolio of U.S. equities, a tool commonly employed in the recent past by pension funds. Many plans wanted additional exposure to the S&P 500, but were already at their 30% foreign-content limit. To sidestep this(now obsolete)constraint, they invested their assets in money market notes and bought S&P 500 futures. Despite the use of leverage in this overlay strategy(the futures are held “on top” of the money market investments), the net result is a risk exposure nearly identical to that of an S&P 500 index fund, which is generally not considered risky. This familiar use of leverage does not magnify the gain or loss of an S&P 500 index fund, it simply mirrors exposure to one.
Finally, consider the use of leverage in liability matching, relevant to any plan sponsor. As interest rates have steadily declined over the last 25 years, it has become more and more important for plans to find assets that match the duration of their liabilities. The traditional portfolio mix of 60% equities and 40% bonds has meant only 40% of a plan’s assets are directly affected by long-term rates, compared to 100% for the liabilities.
Since the liabilities typically have twice the duration as a standard universe/ broad market bond portfolio, plans have found themselves with only 20% interest rate coverage. This could be increased to 100% by replacing the equities with bonds and converting all of the bonds from universe to long bonds, but this would, of course, sacrifice the superior longterm return of equities.
Leverage offers a solution to this trap. An overlay of long bonds can increase the interest rate coverage of a plan to 100% without sacrificing the equity portion of the portfolio. Because this strategy results in 100% exposure to long bonds along with 60% exposure to equities, it may, at first, seem risky. And it may, indeed, be risky in asset-only space; however, in the context of liability matching, this strategy, is in fact, less risky. The volatility of the surplus(assets minus liabilities)decreases due to the better matching of interest rate exposures on both sides of the ledger.
For a similar example, consider a pension fund that has a small portion of its liabilities with a 40-year duration. The plan decides to buy a 40-year duration asset to match the liability, but such an asset cannot be found. Why not then buy a 20-year duration asset twice, once with cash and once with leverage?
Some would point out that this strategy has some yield curve risk, since 20 and 40-year duration assets may not move in tandem. But the most significant risk—duration—will be controlled. This strategy, despite its leverage, would be entirely appropriate and not risky relative to the liability. In fact, not levering the portfolio and instead sitting in a shorter-duration portfolio is the riskier strategy.(At the extreme, take the case of a pension fund that invests all of its assets in treasury bills. This is not a levered strategy, but it is certainly very risky with regards to liability matching.)
WEIGH THE RISKS
This strategy may not appeal at first glance to an underfunded plan, which may elect to retain a liability mismatch with the hope that interest rates will rise, increasing the value of its assets relative to the value of its liabilities. But interest rates have developed a habit of falling further despite all expectations, and even underfunded plans should weigh the risks of not using leverage carefully.
With the examples out of the way, there is one final objection often raised against leverage that should be addressed: You can lose the same dollar twice. For example, if a pension fund constructed a portable-alpha strategy using an S&P 500 futures overlay along with a market-neutral hedge fund investment, the concern is that the S&P 500 will fall at the same time that the hedge fund suffers a negative return. That is possible, but the same problem exists with a traditional portfolio. The long-only manager you hired may underperform his benchmark as that benchmark declines.
Some say the traditional strategy cannot lose more than the initial investment, while the levered strategy can. But this cannot happen unless the markets to which the investor is exposed both go to zero instantly, as a methodical rebalancing process would reduce one exposure as the other falls.
The subject of leverage will be coming up more and more often. As described above, it can be associated with currency strategies, portable alpha, hedge funds and duration-extension strategies. The point that plan sponsors should keep in mind is that leverage is not generic. Its use can be simple or complex, and its appropriateness, like that of any investment, can only be evaluated in the context of your objectives and constraints. But as a powerful tool that can help reduce risk, this careful evaluation is certainly worthwhile.
Kevin LeBlanc is managing director with TD Asset Management Inc. in Toronto. kevin.leblanc@tdam.com.
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