Most value investors avoid using leverage in their portfolio, Baupost Group’s Seth Klarman only uses it for the odd real estate deal for example, because it doesn’t just increase the amount of risk in your portfolio but the chances of actually losing capital. But if you have a target rate of return that you need to hit, AQR Capital Management co-founder Cliff Asness argues that adding leverage is a better way to manage your portfolio’s risk than changing asset allocations.
Facing a balanced portfolio with low expected returns
“We do not think leverage is riskless. Run screaming from anyone who believes that,” says Asness. “We simply believe, in moderation, leverage is a better risk to take in pursuit of higher returns than is the risk of concentration.”
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Asness is really talking to other people who are following a risk parity strategy with part if not all of their portfolio. Allocation strategies that focus on dollars, like the classic 60/40 portfolio, instead of balancing risk is a different game plan (and not one that Asness supports). The question is, if you’ve balanced different risk assets in your portfolio to the best of your ability and the expected returns are unacceptably low, what should you do?
One option is to add leverage to the same portfolio, so the risks go up but remain balanced, and the other is to trade lower for higher risk assets. Neither is risk free, and the unbalanced portfolio will outperform precisely when higher risk assets outperform, but Asness argues that you are better off increasing leverage than straying from the asset allocation you believe is optimal.
Leverage isn’t just for getting aggressive, says Asness
Of course putting this strategy to work assumes that you’re able to put together a good risk-balanced portfolio in the first place, otherwise you’re just magnifying your own mistakes. Done correctly, Asness argues that you can end up with the same overall risk as traditional portfolios with higher expected returns.
“Leverage is not used simply to get more aggressive. It’s used to balance risks better across the asset classes. After that’s accomplished, it’s used to get as aggressive as desired, usually only getting back to the risk of more traditional allocations,” he writes.
Even if the portfolio is sound you will need to prepare for the worst. Asness recommends having a firm plan to decrease leverage as losses pile up, and then add the leverage back after markets have recovered.
Correction: The previous version of this article said that investors should add leverage back at the market bottom, but Asness recommends risk control, not market timing strategies.