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What's More Risky: Concentration or Leverage? Thumbnail

What's More Risky: Concentration or Leverage?

Until recently, individual investors have been essentially "forced" into an all-stock portfolio if they desire higher returns. However, through evolutions in the ETF and mutual fund landscape, investors now have another option: leverage.

Most investors are understandably averse to leverage. This post aims to compare the historical risks and returns of a 100% stock portfolio compared to a portfolio employing leverage.

What is Concentration vs. Leverage?

If you want to achieve higher investment returns, you have a choice: concentration or leverage.

Concentration means investing heavily in an asset you think will perform best. For example, many investors with long time horizons hold stock-centric portfolios because stocks have performed well over the long run.

Leverage means borrowing to increase your exposure to an asset or portfolio. Most investors are averse to using leverage because of the well-documented financial calamities which have resulted from leverage.

I believe that applying a modest amount of leverage to a well-diversified portfolio is less risky than concentrating into stocks.

To test this hypothesis, let’s compare a 100% stock portfolio to a well-diversified portfolio levered up 1.5 times.

An Overview of the Two Portfolios

In this post, we will compare a 100% global stock portfolio to a levered-up, well-diversified portfolio.

The 100% global stock portfolio will be proxied by 60% U.S. stocks and 40% International stocks using Vanguard Index funds (60% VTMSX, 40% VGTSX). These weights mirror the current weights of the global stock market.

The “well-diversified” portfolio will be proxied by a mix of 30% global stocks (broken down in the same weights as the 100% stock portfolio), 55% bonds, and 15% gold. This portfolio is a simple “Risk Parity”-style portfolio, with exposure to asset classes which tend to perform well in all macroeconomic environments. The portfolio is a simplified version of the Risk Parity-style portfolio Ray Dalio suggested during an interview with Tony Robbins in the book Money: Master the Game.

Although the 100% stock portfolio is diversified in the sense that it holds nearly all of the world’s stocks, it is not as diversified as the Risk Parity-style portfolio because all stocks tend to perform poorly in recessionary or stagflationary environments.

Below is a graphic of the four major economic environments. Stocks tend to perform well when growth is accelerating, but very poorly when growth is slowing. The Risk Parity-style portfolio is more diverse in its exposure to all four of these environments.

Major economic environments and the assets that perform well in major economic environments.

Unleveraged Comparison

Below is a historical performance comparison from May 1996 through December 2023 of the two portfolios before applying leverage. (Note: May 1996 marks the beginning of the period because this is when the Vanguard Total International Stock Fund (VGTSX) came into existence.)

Global Stocks outperform the Risk Parity portfolio by nearly 1.5% per year during this period. But Global Stocks also exhibited significantly more risk than the Risk Parity portfolio, with stocks dropping as much as 54% during the period studied compared to only 15% for the Risk Parity portfolio.

Applying Leverage

We will apply leverage to the well-diversified portfolio to compare the performance and risk of the Global Stock portfolio to a levered portfolio. For comparison’s sake, we will lever the Risk Parity-style portfolio 1.5 times.

This means we will borrow 50% to invest an additional 50% into the Risk Parity portfolio. The 1.5x Risk Parity portfolio will be proxied by 45% Global Stocks, 82.5% Bonds, and 22.5% Gold, at a cost of -50% cash plus 0.50% per year.

The cost of leverage is assumed to be the Cash yield plus 0.50% per year because this has historically been the embedded financing rate of the futures markets. Cash plus 0.50% is also the financing rate investors should expect through certain ETFs employing leverage.

Performance Comparison: 100% Stocks vs. Leveraged Risk Parity

Below is the performance comparison of Global Stocks to the Risk Parity-style portfolio leveraged 1.5x.

Now the two portfolios have very similar performance, with the levered portfolio slightly outperforming from May 1996 through December 2023.

But at what cost? What risk did the leveraged investor need to take to arrive at these similar returns?

By virtually all metrics, the leveraged investor took less risk than the Global Stock investor.

Risk Comparison: 100% Stocks vs. Leveraged Risk Parity

Although the returns for the two portfolios were very similar, the experience of holding the portfolios was vastly different.

Let’s compare the experience of the 100% stock investor to the Leveraged Risk Parity investor during this timeframe.

Risk Metric 1: Drawdowns

A drawdown is a peak-to-trough decline for an investment and is measured in both severity and length. The severity of a drawdown is the maximum decline from a previous peak. The length of a drawdown measures how long an investment is “underwater,” or how long an investment goes before reaching new highs.

Below is a graph of drawdowns for Global Stocks (blue) and the Levered Risk Parity portfolio (red) from May 1996 through 2023.

Both the severity and the length of stock market drawdowns stand out during the Dotcom bust (2000-2003) and the Global Financial Crisis (2007-2009). Global stocks were underwater for over 5 years during both of these periods.

Below is another comparison of drawdowns during historical market stress periods. Although stocks recovered from each of these events, it takes a significant amount of fortitude to stay the course as an aggressive investor.

Risk Metric 2: Ulcer Ratio

A second risk metric to assess the “pain” an investor must endure on the way to returns is called the “Ulcer Ratio.”

The Ulcer Ratio was developed in the late 80’s by Peter Martin and essentially quantifies the severity and length of drawdowns. The ratio can be thought of as totaling the area of the maximum drawdown graph from the previous section.

Lower Ulcer Ratios mean an investment has experienced relatively shallow and short-lived drawdowns. While higher Ulcer Ratios indicate deeper and more prolonged drawdowns.

Given the drawdown statistics of Global Stocks vs. 1.5x Risk Parity, it shouldn’t be a surprise that the Ulcer Ratio for Global Stocks is 16.0 compared to 5.0 for the leveraged Risk Parity portfolio.

Risk Metric 3: Timing Sensitivity

A third risk metric is the variability of rolling returns. How much of a difference is there from year-to-year or from one five-year period compared to another?

The below table charts the average, highs, and lows or different rolling return periods for Global Stocks compared to 1.5x Risk Parity.

Some investors may be surprised to learn there was a 10-year period where stocks were negative. Although the levered risk parity portfolio experienced negative one- and three-year periods, there was not a negative five-year period.

Below is a graph of the rolling five-year returns of Global Stocks compared to 1.5x Risk Parity. Global Stocks have had far more variability in five-year returns compared to the Risk Parity portfolio.

Conclusion & Next Steps

Investors are understandably averse to using leverage. However, the prudent use of leverage can magnify returns without taking excessive risk.

In this example, a leveraged risk parity-style portfolio generated similar performance to a global stock portfolio with significantly less risk.

The results of this demonstration are consistent with financial theory and are far from new. The idea of applying leverage to a well-diversified portfolio has been employed by institutional investors for decades.

What is new is the ability of individual investors to employ the same strategy through ETFs and mutual funds.

To learn more about how Kardinal Financial employs this investment strategy, visit the Contact page to schedule an introductory call.