Leverage Isn’t Free

I’ve been running across an idea that outperformance is possible with safe assets, so why not take those assets and lever them up until their volatility is equal to common equities, and earn more at the same level of volatility?  That was my only significant disagreement with the book Expected Returns.

I think this is a stupid idea.  (I don’t favor the CAPM either.)  When you borrow money to buy some asset, the distribution of possible returns changes.

Let me give you some analogies.   First, securitization.  Those that invest in non-senior loan tranches get an enhanced yield, but they face a different risk profile than most corporate bond investors.  Corporate bond investors have a high expectation of full payment, but when default occurs, they lose 60-80%.  Investors in securitized bonds rarely get recoveries.  They usually get paid in full or lose it all.

Second, think of banks or REITs.  They lever up safe assets, and they blow up with a higher frequency than do industrial corporate bonds.

Leverage changes the nature of the distribution of possible returns in three ways:

  1. The cost of borrowing decreases the return.
  2. The returns are levered by the amount of borrowing.
  3. To the degree that others do the same thing, the strategy is no longer undiscovered, and superior returns should not be expected.  In a crisis, the borrowed money leads to overshoots as panicked investors bail out en masse.

Personally. I wish we could get rid of the writings of academic economists and finance writers that don’t actively invest.  They don’t get the dynamics of investing, and assume a simple world that does not resemble our world.

My main point is that trying to buy the asset class with the highest return after equalizing volatilities is a fool’s bargain.  Adding leverage changes the nature of decisionmaking, and what tests in the lab will not likely work in real life.  Paper trading does not always translate to real world profits.