A fundamental tool of modern portfolio theory fails to account for unique risks of leverage, according to two investment managers.
That incompleteness can cause investors to take on more risk than intended and create excessive risk to the financial system that might trigger turmoil leading to events such as the 2008 market crisis.
The mean-variance optimizer — a foundational tool in modern portfolio theory that investors use to select investment portfolios optimized with the best expected returns to match risk tolerances — has volatility as its only source of risk, said Bruce I. Jacobs, principal of Jacobs Levy Equity Management Inc., Florham Park, N.J.
“Modern portfolio theory doesn't recognize the unique risk of leverage,” Mr. Jacobs said. These risks include abrupt margin calls, forcing portfolio managers to liquidate securities — selling long positions and covering short positions — at adverse prices and possibly causing portfolio loses beyond capital invested. That's an especially relevant scenario in the contemporary market as pension funds and other institutional investors increase their use of leverage in their portfolios to enhance investment strategies.
“Leverage has contributed to or caused many ... financial crises we have experienced.” Mr. Jacobs said. “Whether the leverage is in the housing industry, investment banks or hedge funds, the impact has been profound. With less leverage in the system, the likelihood of systemic crisis is lessened.”
“If investors were to recognize in their portfolio optimizations their aversion to these unique risks of leverage, there would be less leverage in the system and possibly fewer systematic events,” Mr. Jacobs said.
“MPT recognizes the increase in expected volatility associated with using leverage,” Mr. Jacobs said. “But it does not take into account the unique risks of leverage.”
To overcome that MPT shortcoming, Mr. Jacobs and Kenneth N. Levy, also a principal of Jacobs Levy, have modernized the mean-variance optimizer to add a factor for leverage risks along with the existing volatility risk factor.
Their work transforms the mean-variance optimization's output — the efficient frontier, a set of optimal portfolios that reflect the best return for a level of risk along a two-dimensional curve — to trade off between the two factors of expected return and volatility risk. By adding a factor for leverage risks, they transform the optimizer to create a set of portfolios optimized for expected return, volatility risk and leverage risks along a curved three-dimensional efficient frontier surface.
“That is what we are bringing to bear” in the new work, Mr. Jacobs said, noting it expands the efficient frontier and shows tradeoffs between expected return, volatility and leverage risk.
Messrs. Jacobs and Levy describe the transformation of MPT in two papers, one published in October in the Financial Analysts Journal, and another coming in its spring issue, expected in May.
“As you leverage a portfolio, the volatility will increase,” Mr. Jacobs said. “So there is recognition in MPT that leverage gives rise to (more) volatility, but MPT doesn't account for unique risk of leverage.”