INVESTED: In Markets, in the Future, and in Society.

Leverage. The bogeyman in financial markets. A word that investors typically hear and shudder. And indeed, applying leverage to a complex derivatives trade, or a single stock, or a single asset class, can end in tears. History is littered with tales of how excessive leverage and risk-taking, often a derivative of greed, has led to the demise of investors.

However, as with most things, the truth is much more nuanced. Typically, when thinking about a portfolio in liquid markets, if an investor wants to increase return and risk, they will increase their allocation to stocks. Which in turn increases concentration risk—that is, increasing the dependence on a select few factors to drive returns. However—there is a better way. We’ve long been writing about how the intelligent application of leverage on a diversified portfolio can actually decrease risk.

This article from Man Group states that “leverage can be used to improve diversification and risk-adjusted returns, while minimising the concentration in the portfolio”. The author, Tarek Abou Zeid, goes on to discuss how typical “balanced portfolios” are actually dominated by equity risk, which is a central problem that risk parity models attempt to solve. He also demonstrates how dynamic risk models, such as volatility scaling, can lead to less risk during times of stress versus a conventional “balanced” portfolio. These are messages that underpin our risk parity philosophy and that we firmly ascribe to at Viewpoint.
It’s easy, and natural, to classify problems into black versus white, but the reality is that most things in markets, and in life, are in fact shades of grey.