Is Leverage Risky?

Leverage often gets a bad rap in finance, and for good reason. We’ve all heard stories of large hedge funds, or you know… banks, that have been overexposed to certain markets, and unraveled when the bet went against them. 

But is it the leverage that’s at fault, or its use?  

Let’s consider an example. We’ll start with an all stock portfolio, and use leverage to buy 40% more stock. (100% Stock vs. 140% Stock)

This looks pretty good! This should come as a shock to no one. If stocks are good, more is better.

But could anyone have realistically hung on to this portfolio? Remember that even though you’re getting 40% more return, you’re also taking 40% more risk. Let’s see how much these portfolios would’ve fallen in the past.

The above is called a drawdown chart, which looks at how much an investment is down at any point from its previous high. As you’d expect, levered stocks always fall more than without leverage. In 2008, you would have been down nearly 70%! 

This is risky leverage. Sure you can increase returns significantly, but the volatility is so high that it can lead to investor mistakes. 

But stocks aren’t the only thing you can buy with leverage! What if you bought something that typically lowers risk, like bonds? In theory, you’d receive the return of bonds, plus get the diversification benefit in bad markets like 2008. 

Of course bonds have their own unique risks, so ideally you’d like several diversifying investments to leverage into. 

Let’s try another example. We’ll keep the 40% leverage, but instead use half of it for treasury bonds, and half of it in another historically great diversifier, managed futures. We’ll add that series to the chart below. Remember, the stock portion of these all these portfolios are identical, we’re just changing the 40% leveraged portion.

In this example, performance improves even more by leveraging into diversifiers than in stocks. This is despite stocks having performed better than either treasuries or managed futures in this time period!

This is counter-intuitive, but the reason is because of how much shallower the drawdowns are. The reduced volatility from bonds and alts allows the portfolio to compound more efficiently, even if their average return wasn’t as high as stocks. You can see this in the updated drawdown chart below: 

As you can see, leverage by itself ≠ more risk. It all depends what you leverage into. In fact adding 40% leverage into bonds and alts had lower drawdowns than the unlevered stock portfolio. 

Hopefully this illustrates the difference between simply leveraging up a portfolio to boost returns, and strategic leverage to improve all aspects of a portfolio. The portfolio in this example is illustrative, but takes a similar approach to our Enhanced Growth portfolios. If you’re interested in whether this type of portfolio makes sense for you, please read our retirement whitepaper, or give us a call to discuss. 

If this helped you see leverage in a new light, consider sharing it with friends, family, or colleagues who might also benefit from understanding how strategic leverage can improve a portfolio.

PAST PERFORMANCE IS NOT A GUARANTEE OF CURRENT OR FUTURE RESULTS. Examples of historical information included in this presentation do not, nor are they intended to, constitute a promise of similar future results. Specific client portfolio allocations, risks and returns can and may deviate from these examples depending on accounts and types of investments available through each account. Future market views by WJ Interests, LLC may vary significantly from the historical examples presented herein and no one receiving this summary should assume that WJ Interests, LLC will be able to replicate successful views in the future. 

“Stocks” and “Stocks + Leverage” are for illustrative purposes only. They are calculated by taking a weighted average of the following asset classes and represents an aggressive risk portfolio incorporating leverage and the asset classes in the table:

Assumes Monthly Rebalancing. All data represents total return for stated period.