Several pension funds recently announced plans to use or consider using borrowed funds to lever assets. Sometimes called risk parity, these strategies reduce equity allocations while leveraging fixed-income holdings in an effort to capture equitylike returns with less risk. I suggest, however, that this “leverage solution” lacks a firm foothold in investment knowledge and practice and should be viewed with great caution.
The poor outcomes associated with reaching for returns are well known. Consider how a large dose of equities was once prescribed to assuredly deliver a solid return over the long haul. Then came various “uncorrelated” strategies touted as sure to deliver higher returns at lower risk — exotic betas, hedge funds, and private equity. Now, the new thing is levered bonds. Once again, some are reaching for returns in all the wrong places.
Given the underfunded status of so many pension plans, the desire for high returns is understandable. In a well-diversified portfolio, numerous asset classes and strategies can play an appropriate role. Many sponsors, however, seem intent on trying to justify high expected-return assumptions while paying only lip service to the risk taken to reach that high expected return. Of course, high risk sometimes means that returns are much higher than expected. But it can also mean that returns are far lower, perhaps crippled beyond hope of redemption. Given the reality of fat tails, the likelihood of large negative events is also higher than normal. And poor results can persist for long periods. By now, the myth that risk “goes away” over time should be well put away — risk accumulates over time. In short, investors cannot expect to “get” the expected return, but rather a draw from a very wide distribution. And in reaching for high returns by using leverage, investors dwell in the extremes of the return distribution.
The risk-parity idea is that fixed-income investments somehow have a better Sharpe ratio than the diversified market portfolio. Thus, gearing up the fixed-income portfolio component will give a higher return but with less risk. Using leveraged bonds, however, just means more risk for specific factors — in this case, real interest rates and inflation. During good markets for these factors, the risks pay big; but in bad markets, the risks take an equally large bite.
In short, using leverage simply to increase the expected return is almost always a bad idea. There is no free lunch, no magic way to beat the market with leverage. The increased risk is real. Beating the market requires a special alpha insight. Leverage is not such an insight.
For pensions, the elephant in the elevator is economic liability. Hedging this liability can be accomplished with long Treasury inflation-protected securities and, to a lesser extent, nominal bonds. So, leveraging up TIPS to match the liability is a legitimate approach because the liability faces real risks to inflation. So long as the net of assets and liabilities cancel each other out, the risks also cancel each other out — the risks do not increase. Such an approach hedges risk. Unlike simple leverage, it does not add risk. But plans must first seek to match their liabilities and then decide how many risky assets to own.
The need for solid risk management is real. Today, most sponsors cannot afford to recoup any investment losses — they hurt when the market hurts, which places future commitments at risk.
That this leveraged-bond strategy is emerging after a long bond bull run and poor equity performance is curious. This likely hindsight-driven idea runs strikingly close to the frequent overweighting of equities during the late 1990s and the more recent affinity for uncorrelated assets during the early years of this century. Asset allocation decisions should never be made by simply extrapolating the future from the past.
Consider, too, that bonds play an important role in protecting against adverse outcomes. Far from mitigating risk, adding a leveraged-bond component tosses this padding out the window. Furthermore, nominal bonds may not provide the steady performance of yesteryear, especially in light of looming government budget deficits and explosive monetary stimuli, which may lead to higher rates and poor performance for bond portfolios.
In searching for a free lunch, investors have come upon yet another false investment solution. This latest approach may pose a double whammy: mismatched real durations on the back of hindsight-driven leverage. Let economics — not an unreasonable hope for fortuitous good luck — drive investment decisions.
Rodney N. Sullivan is head of publications and editor of the Financial Analysts Journal at CFA Institute, Charlottesville, Va.