At its simplest, leverage denotes the use of borrowing to fund an asset purchase, which increases potential returns but also potential losses. It can come in various forms, and when evaluating different investment strategies, it’s incumbent to step back and understand the type of leverage being used.
This is particularly true in the alternatives space where many strategies seek “enhanced returns” (defined here as high single to mid double digit net portfolio returns) and often need to employ some form of leverage to achieve them, particularly in a world of lower expected returns.
For investors in these strategies, understanding the interplay between the type and cost of leverage, and an asset’s cash flow profile and return volatility, is critical to understanding the risk that leverage adds.
CASH FLOW UNCERTAINTY AND ASSET VOLATILITY
In theory, the return of an asset should be commensurate with the variability of its cash flow, and the more uncertain the cash flow, the higher the expected return should be. Whatever the source of the cash flow uncertainty, be it default, convexity or economic risk, quantifying it is essential in ensuring investors get fairly compensated for the risk they are taking, as well as being able to compare return profiles across asset types. This is critical when leverage is applied, because if the downside or uncertainty becomes worse than anticipated, large losses can ensue – commonly referred to as fat tail risks.
In an ideal world, investors seek assets with return profiles that are more certain and offer limited downside, while maintaining upside optionality – an asymmetric payoff profile. Often, being in a secured position relative to an unsecured position can provide this by limiting downside during periods of economic weakness. Non-agency mortgage-backed securities, for example, arguably exhibit an asymmetric payoff profile. As the securities trade at a deep discount to par, an investor can earn a positive or small negative return on the assets by holding to maturity, even in a weak housing environment, while maintaining upside if home prices appreciate. If one can find attractive profiles such as this, the addition of leverage can potentially enhance returns.
Likewise, if an asset offers a risk premium that is less correlated to economic events, then prudent use of leverage can also be beneficial. For example, in today’s environment we think regulatory factors, accounting considerations, ratings arbitrage and liquidity constraints are generating attractive risk premiums on select assets (call it a liquidity or complexity premium). Investors can capture this premium, and with prudent use of leverage can potentially deliver enhanced portfolio returns. In doing this however, it’s critical that the source of the risk premium is the liquidity or complexity premium. If instead it is simply economic variability, then applying leverage can make the return profile significantly riskier.
In certain cases, leverage doesn’t need to be applied to meet enhanced return targets. Distressed assets, restructurin