It is a plain fact that much of what is marketed as "outperformance" in funds using securities lending, as well as in certain types of "enhanced" index funds and many bond funds, is simply the product of leverage. The chief problem with this leverage is not its existence, but rather its disguise. That is, the use of leverage often is being ignored, hidden, or worse, used to mislead investors about the investment manager's ability to add value.
By failing to make full disclosure, advisers are violating the spirit, if not the letter, of the performance standards set out by the Association for Investment Management and Research that require disclosure of the use of leverage in reporting investment results.
The reason leverage matters is that it entails special risks, namely, that the excess returns produced by leverage - "risk premia" - are positively correlated with the returns of an asset portfolio. Because returns from leverage are the product of systematic risk, the decision to use leverage is an asset allocation decision, not a security selection decision, and it must be treated as such. Moreover, to the extent that leverage is confused for true "alpha," or the value added by manager skill, the plan sponsor will invariably be overcharged for an activity more akin to index management than superior security selection.
Securities lending
Leverage is simply the act of having more than 100% of the underlying assets in an investment pool invested in risky assets. In my Sept. 4, 1995, commentary, I showed how leverage is a common, although obscured, part of most securities lending. Critically, investment advisers and custodians are adding leverage to their securities lending portfolios if they are investing the collateral in anything other than Treasury bills (because this results in more than 100% of the fund being invested in risky assets).
Contrary to what some parties have claimed, leverage and the consequent "investment management" required to deal with the risky assets obtained through this leverage are not a necessary part of securities lending. Rather, if the aim is to garner marginal fees through securities lending - and if there are any genuine securities lending fees to be garnered - they can be had using T-bills as collateral. The only reason for using risky assets as collateral for lent securities is to obtain leverage; whether or not this activity is beneficial or not, it should be disclosed for what it is.
Enhanced index funds
Like some types of securities lending, many enhanced index programs also are based on the use of leverage. In the leveraged version of enhanced indexing (as opposed to other types of enhanced indexing that attempt to add value through superior security selection or other true alpha activity), the manager buys Standard & Poor's 500 futures and collateralizes them with, for example, a short duration bond fund.
In other words, 200% of the portfolio is invested in risky assets: 100% in S&P 500 futures and 100% in short duration bonds. Such an enhanced index fund will have returns greater than the S&P 500 index insofar as the enhancement vehicle - actually the realized risk premium on duration extension or credit risk - outperforms T-bills.
However, in an inflationary environment detrimental to the returns of bonds and stocks (say, 1974), such a portfolio would perform disastrously. The risks of such a fund are essentially different from and greater than those of a traditional, actively managed equity fund, and yet enhanced indexed managers misleadingly suggest their funds should be viewed as a reliable source of "alpha" and a ready substitute for active large-cap managers.
Bond funds
Another, far more subtle form of leveraging routinely takes place in enhanced index bond funds and often even in traditionally managed active bond funds. In these funds, managers all too often systematically substitute other, usually more risky, sectors of the market for less risky sectors found in the index.
The Lehman Aggregate Bond Index, for instance, contains about 50% Treasury securities. The manager may, however, consistently overweight corporate debt or mortgages in lieu of Treasuries. But whereas Treasuries only involve interest rate risk, corporate bonds also have credit risk and mortgages have the risk of negative convexity.
Other such strategies include buying Treasury futures or mortgage forwards and collateralizing these contracts with commercial paper instead of T-bills. These substitutions - if systematic - constitute financial leverage because the asset allocation decision was made on the basis of an index that contains 50% Treasuries not 5% Treasuries. Therefore the manager is compounding one type of systematic risk - duration - with another, credit risk or convexity risk. In short, the manager - rather than the plan sponsor - is now adding risk premium to the portfolio.
Inappropriate benchmarks
Investment managers leverage their clients' portfolios because compounding risk premium in a fund has an expected return. Insofar as this higher expected return can be passed off as outperformance resulting from skill, a manager may be able to justify a higher fee - or a manager's very existence.
To obscure the use of leverage, some managers will claim they are not adding leverage to their portfolio and that their above-benchmark returns are the result of alpha. They'll point to the fact that the observed risk (or standard deviation of return) of their fund has been similar to or lower than that of the benchmark (such as the S&P 500).
This is a spurious argument, however, because it is the result of regressing a multiasset portfolio against a single asset benchmark. In fact, what the manager has done is to convert beta gains - the benefits of diversifying risky assets - into extra return through leverage. The manager has misspecified the market.
The true index or market proxy for an "enhanced" S&P 500 index fund, for example, is complex. It would have to include the S&P 500 index minus T-bills (which is the effect of holding futures) plus a customized short-term bond index representative of risks in a short duration portfolio.
Measured against the proper market benchmark, the alpha is all too often found to be wearing no clothes. The point is, such an enhanced index fund, which is more accurately characterized as a "leveraged balanced fund," is more risky than a typical actively managed account when measured against the benchmark that counts: the true market portfolio.
Is it leverage?
Another problematic claim is that leverage is not being added to a fund if the collateral (for futures positions or lent securities) is invested in a short-term investment fund, or STIF. Unfortunately, these cash vehicles are risky assets. The risk premium on such a cash product is essentially the TED spread, or T-bill under Eurodollar spread; this spread has an expected return precisely because (as the capital asset pricing model implies) it entails systematic risk or a risk that cannot be diversified away. The risk of the TED spread cannot be diversified away because it widens when returns on other assets are also hurt, that is, in times of crisis when it looks as if short-term borrowers will have a harder time paying back their loans.
Consequently, a portfolio consisting of S&P 500 futures collateralized by commercial paper will introduce more risk - particularly downside risk - into a portfolio than futures collateralized by T-bills. For instance, between August and November of 1987, a period in which the S&P 500 fell by about 30%, the TED spread widened from about 75 basis points to more than 260 basis points. Although this widening never resulted in a lower monthly return for LIBOR, or the London interbank offered rate, (only a reduced return premium) vs. T-bills, it is indicative of a risk that might turn ugly in more dire circumstances.
As with every asset class, the TED spread has an expected return for a reason: the systematic risk that the holder bears. To plumb recent history, find that it has been rewarding to hold a leveraged position in a certain asset, and then to declare the existence of a market inefficiency is not good practice; it is simply data mining. Of course, that is not to say the risk shouldn't be taken, only that it must be reckoned with, not ignored.
Investment advisers who make use of leverage - including commingled funds that use securities lending with risky collateral; leveraged enhanced indexes; and many bond funds - should reveal that they are using leverage and break out returns produced this way from those that have been produced through investment management skill. It would seem AIMR standards demand it.
Distinguishing leverage from alpha
Needless to say, plan sponsors and their committees need to be cognizant of the disguised leverage in their portfolios. Distinguishing leverage from alpha is a sine qua non of portfolio risk management. Decisions involving leverage are ones of the allocation of risk premium - in short, they are asset allocation decisions. As such they must be subject to asset allocation modeling and committee decisions about how much risk the plan is prepared to take.
Whether or not plan sponsors ultimately decide that such leveraged funds are appropriate, they must analyze them for what they are.
Failure to take explicit account of leverage is a failure to understand the total risk of the plan.
Insofar as plan sponsors mistake a commodity that is easy to produce, namely, leverage, for a commodity that is hard to produce, namely, alpha, they doom themselves to unnecessarily higher fees.
Todd A. Tibbetts is manager-trust investments and foreign exchange at Sandoz Corp., New York.
