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. Like any tool, it can be used poorly and cause harm. Leverage demands that you act in specific, prudent ways.
The first is moderation. There are limits to the logic I’ve outlined above. A diversified portfolio that must be levered 2-to-1 to match the risk of its more concentrated but inferior cousin might be wise, but a trade you believe is very low risk that must be levered 25-to-1 to matter probably isn’t.
Second, mark-to-market leverage only works with reasonably liquid assets, where the liquidity horizon is linked to the term of the leverage. The wrong form of financing plus illiquid assets is what we call, with only some hyperbole, the death combination.
Finally, in our view levered strategies work best when married to drawdown control — temporarily pulling back when losses mount. Maintaining a levered strategy with no “give” in the face of losses is impractical. Rather than never giving in, you often end up capitulating at exactly the costliest point. Of course, this can happen without leverage as well, but at least then it’s your choice, not at your lender’s insistence.
We believe that following preplanned systematic drawdown control is less costly than many think, as you don’t just cut positions at the bottom but do so smoothly if losses grow; similarly, you add back positions smoothly (something far harder to do if you held out to your breaking point). Also, assets often show some tendency to trend in the short term, mitigating potential costs of this action.
Prudent use of leverage adds a small cost and a greater need to manage this tool, but in our opinion that’s a modest price to pay versus being forced to run concentrated portfolios reliant on a few asset classes and strategies and lacking the benefits of diversification. Used shrewdly — to diversify, not simply to take on more risk — leverage is your pal, not the bugaboo that conventional wisdom paints it to be, we believe. There will always be those who don’t use leverage wisely but instead employ it to take oversize — and, ironically, often very concentrated — bets. This remains an area that both conventional wisdom and our unconventional viewpoint agree is usually a bad idea (though the world will still fete those who get such bets right, a topic for another day).
Clifford Asness is managing and founding principal of Greenwich, Connecticut–based AQR Capital Management. See his popular feature, “The Great Divide over Market Efficiency.”
