Tuesday, February 09, 2010

Leverage Can Reduce Risk ???

That’s the conclusion of the State of Wisconsin Investment Board after it authorized a strategy to lever up its pension plan assets from 4% this year to as much as 20% over the next 3 years. This strategy, generally referred to as “risk parity”, has been used for several years by a number of well known hedge funds, including several which advised the Investment Board.

The essence of a risk parity strategy, which is showing up in public pension board room presentations across the country, is that an expected return rate similar to a traditional 60% equity portfolio could be supported with less volatility by using leverage to boost exposure to lower risk asset classes in a plans asset allocation. Leverage provides a way to ratchet up the returns of the lower risk assets while altering the portfolios risk profile by reducing the proportion of equity risk, the risk that has traditionally dominated most pension portfolios.

While it is not surprising that portfolio risk has taken on a more visible role in asset allocation strategies, it perplexes many that leverage, the proximate cause of the 2008 and other past financial crises, is now the centerpiece of a risk reduction strategy.

The theoretical case for using leverage in a risk parity framework to reduce risk for any given expected return level is sound. It follows the well accepted mean variance, efficient frontier framework that most pension plan sponsors have already accepted as a foundation for their asset allocation decisions. Risk parity simply factors in the ability to borrow at a rate less than or equal to the savings rate. When borrowing is considered, the efficient frontier (the set of portfolios that maximize risk adjusted returns) moves from the concave curve we are all familiar with to a tangent line to the curve originating at the risk free rate. Visually, the equivalent return portfolio on the borrowing frontier has less risk than on the concave frontier

While the risk of higher leverage is dependent on the predictability of the levered risk (in this case fixed income risk is regarded as a much lower risk than equity), the practical case for using leverage may not be as elegant as the theoretical case. Leverage tends to seduce investors because it amplifies investment results. While small amounts of leverage, like the 4% WIB starting position, can’t do irreparable harm, positive outcomes will inevitably lead to overconfidence and higher leverage. Higher leverage will eventually collide with unanticipated market conditions creating the potential for another species of leverage induced portfolio meltdowns.

Just like external leverage in the form of pension obligation bonds was once considered an attractive option for making up public pension under-funding, risk parity is the new way for plans to borrow their way to abundance. It may not turn out to be a bad strategy for all plans but is likely to damage a few as this theoretical free lunch is just too tasty to resist.

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