Fighting fear of the ‘L’ word

Money managers want to use leverage, but plan sponsors still consider it a dirty word.

The latest firm to push the idea of using leverage is PanAgora Asset Management, Boston, which is incubating its "Risk Parity Plus" portfolio. The new product will take the traditional 60/40 split between stocks and bonds, but boost leverage of the bond portfolio so the risk represented by it equals that of the stock portfolio, said Ed Peters, chief investment officer.

The strategy is similar to the All-Weather Fund, managed by Bridgewater Associates, Inc., Westport, Conn. That fund, which was created in 1997, takes the traditional 60/40 portfolio and increases leverage of the bond portfolio by about 2 to 1 through borrowing and futures, said Ray Dalio, president and chief investment officer. Mr. Dalio said the fund has about $8 billion, mostly from institutional clients, and is designed to return about 10% on an annual basis.

"We don't have to borrow much," said Mr. Dalio. "We can use futures, so there need not be a lot of borrowing."

But plan sponsors — jaded by the high-profile blowups of hedge funds that used excessive leverage, such as the 1997 demise of Long Term Capital Management LLC — are still not convinced that leverage is safe.

"You'll notice the hedge fund managers that have gone bad all used an excessive amount of leverage," said Richard Curtis, executive director at the $600 million Ohio Highway Patrol Retirement System, Columbus. "I have a great deal of concern about borrowing assets so that you can invest more in one strategy, because if something goes wrong, you're on the hook for those borrowed assets. I think some people have learned to use leverage to their advantage. I think you can dampen risk by putting borrowed assets into someplace that's counter-correlated with what you're already invested in. But I think public plans should have leverage limits and enforce them in their contracts."

John Thompson, trust investment manager at TXU Corp., Dallas, a utility that manages a total of $4.3 billion in defined benefit and nuclear decommissioning trust assets, said, "We don't use (explicit) leverage in any of our portfolios, primarily because using leverage increases your risk. We believe that there are other ways to gain alpha without using leverage. We do use futures and swaps in our portfolios, but they are all backed by cash so we don't consider that leverage."

Money managers, however, said plan sponsors should reconsider their hesitation over leverage.

"When a (plan sponsor) invests in a lot of asset classes, there is leverage already embedded in a lot of those assets," said Bridgewater's Mr. Dalio. "Companies issue debt, real estate firms certainly use leverage, etc. So the practical definition of leverage is based on whether I as an entity am doing the borrowing or whether the company I am investing in is doing it. That's where the dividing line is if you buy in to the leverage argument."

Fred Dopfel, a senior strategist at Barclays Global Investors, San Francisco, said use of leverage in an active asset allocation portfolio could be effective. "If you have confident views and skill as an investor, then you can use leverage effectively. But if you're thinking about it from an asset allocation perspective, the potential benefits of using leverage would be minimal."

In BGI's October 2005 pension research report, "Leverage and the Limits of Possibility," Mr. Dopfel points out that the use of leverage would not affect the Sharpe ratio of a portfolio, since the expected return and standard deviation of the portfolio would increase proportionately to the amount of leverage being used. Therefore, he concludes, using borrowed assets in a portfolio only makes sense from a risk/return standpoint if the portfolio is being actively managed by a skilled portfolio manager.

Peter Chiappinelli, senior vice president in the strategic relationship management group at Putnam Investments, Boston, said plan sponsors are slowly warming up to the possible uses of leverage. "When we talk about the explicit use of leverage, I think there is much confusion out there," he said. "Plan sponsors have rules of the road when it comes to risk. I think many of them around the country are beginning to re-look at those constraints. These constraints were of course put on with the best of intentions, but were done so in particular capital markets cycles. Now that the capital markets cycle has changed, I think a lot of them are re-looking at the short constraint, the use of leverage and the prohibition against derivatives. For example, bonds right now have an attractive Sharpe ratio and low to negative correlation to stocks. Using a modest or prudent level of leverage could amplify the virtuous characteristics of that asset class."

PanAgora's Mr. Peters said: "Leverage, like anything if you have too much of it, gets risky. The biggest problem with the hedge-fund blowups was that they usually were caused by derivatives and leverage. Both get bad press."