The Name of the Rose: False Notions About Leverage, Derivatives

use leverage and derivatives because that’s the only way to control them directly. Third, to balance out the risk between the baskets, as opposed to simply the dollars, you’re going to need to control a lot more dollars in your bond baskets than in the stock basket. Why? Because the historical risk to bonds, particularly government bonds, is so much less than the historical risk to stocks. To get an equivalent amount of risk you either have to get rid of almost all of your stocks, which would be a mathematically correct but financially ill-advised solution, or you have to control a lot more bonds. I think it’s wise to choose the latter … with limits, within reason, and constantly adapting to changing market conditions.

What a risk-balancing strategy means by “leverage” is the same as Archimedes meant the word 2,500 years ago, or that generals on the battlefield mean the word today: it’s controlling a lot with a little by using a force multiplier. It’s not borrowed money. It’s not “doubling down” or “turbo-charging” or whatever other misleading phrase your local genius columnist or comment troll throws out there as Gospel. It’s buying an exchange-traded, liquid contract that controls a lot of stocks or bonds or commodities for a little bit of money for a defined amount of time. These contracts are necessary because they are by far the most effective way of implementing what I think is an important new twist on an important old idea – balance your investments across several different asset baskets, but balance by risk (not dollars) and adapt to a changing market.

Does the use of leverage (properly defined) and derivatives (properly defined) create trading risks that wouldn’t be there if you just bought the Vanguard 60/40 fund and called it a day? Sure. But I believe risk-balancing strategies mitigate far more dangerous risks to a public pension portfolio – particularly an over-reliance on equity markets. Public pensions are complex entities whose liability structures are often many times greater than the size of their investment portfolios. The common practice to resolve this dilemma has been to pursue an equity-dominated asset structure that has greater chances of achieving the required return to make the entire structure work. The problem is that equities are themselves leveraged, but it’s hidden leverage and thus hidden risk.

What does this mean, to say that equities embody hidden leverage? It means that the assets of S&P 500 operating companies are nearly five times as large as the equity that finances them. It means that, by definition, the gulf between assets and equity can only be bridged by various forms of leverage. This is the alchemy that transformed a paltry 3.27% return-on-assets for S&P 500 operating companies in 2013 to an impressive 15.01% return-on-equity.¹ For all the equity enthusiasts out there who shake their heads and tut-tut the idea of a few turns of leverage on a liquid portfolio of government bonds, I’d ask why you’re so confident in a 5x equity leverage on the 3.27% unlevered ROA of the S&P 500, but so fearful of, say, a 2x leverage on the 3.44% average interest paid on 30-year government bonds. That’s not a slam on equities. I love equities. Nor is it to say that there’s no risk in government bonds. My point is simply that as an investor you must take risk to achieve a return that is higher than the risk-free rate. There is no way around this, no free lunch, no way to get something for nothing. The question, at least for an investor like most public pensions, is not how to eliminate risk. The relevant questions are: do you know what risks exist in your portfolio, and which of these risks do you want to embrace?

Maybe you just don’t like a risk-balancing allocation strategy, for whatever reason. That’s fine. Or maybe you have a concern or an objection to the strategy or its implementation. That’s fine, too, and believe me, there are plenty of reasonable concerns you could raise or I could raise about ANY investment strategy. But don’t just shout out “Leverage!” as if it were a self-evident condemnation of the strategy or its adopters. It’s like the scene in Steve Martin’s wonderful movie Roxanne, where a heckler in a crowded bar shouts out “Big nose!”. Martin’s response? He’s insulted by the triviality of the insult, and proceeds to whip out 20 superior insults that the heckler could have made (my personal fave – “Obscure: whoa! I’d hate to see the grindstone.”). In this case, I would suggest “Looming: if you thought your leverage and derivative exposures were big, just wait till you see your liabilities.” or “Clairvoyant: if you’re so smart, why use diversification at all?”.

 

I’ll close with two quotes from Will Rogers, who not only never met a man he didn’t like but also had an amazing knack for communicating advanced investment insights without resorting to three syllable words or mathematical equations.

I love these quotes because they encapsulate why Salient recommends a risk-balancing core allocation strategy. We want to embrace risk as an ally rather than treat it as the Great Satan. We do it for the same reason, as Will Rogers said, that you go out on a limb. Because that’s where the fruit is. Risk and reward are entirely inseparable. They are two sides of an unsplittable coin, and you can’t have one without the other. But you need to think about that relationship between risk and reward smartly. More importantly, you need to think about that relationship wisely. What’s the difference? Smart thinks that he can model the future. Wise knows that she doesn’t know what the future holds. Smart is intellectually sharp. Wise is intellectually honest.

Being wise about risk and reward means you don’t claim to own a magical crystal ball that predicts where risk will be low and reward will be high in the future. It means being intellectually honest enough to say that you don’t know. That’s the hardest thing in the investment world to admit, because there is no shortage of smart people who will tell you that they have just such a crystal ball. And maybe they’re right. If you have that crystal ball or you know someone who does … if you are able, as Will Rogers advised, to avoid buying stocks that don’t go up in the future … then you don’t need a risk balancing strategy. Otherwise, let’s have a conversation, or at least listen in by reading Epsilon Theory.

I’m not suggesting that we have a monopoly on new ideas for investing – we don’t – or that our ideas are right for everyone – they’re not. But we believe we are part of an insurgent movement to change the way investors think about asset allocation, and we are buoyed by a consistent lesson from history. The struggle between status quo and insurgent ideas can take a long time and it’s never an easy road for the truth-seekers caught in the middle, but eventually … the Inquisition always loses.

 

• 09_01_2014 The Name of the Rose pdf