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Why I Lever Thumbnail

Why I Lever

Kardinal Financial's Investment Strategy involves combining two concepts: Risk Parity and Capital Efficiency. Put another way, we take highly diversified portfolios (Risk Parity-style portfolios) and use capital efficiency (leverage) to magnify expected returns.

This post focuses on why I lever. (Sidenote: this blog post's title and subject are heavily influenced by a 2014 paper from AQR, entitled Why We Lever.)

The Optimal Portfolio

Every investor should seek to maximize their returns for the risks they are willing to take. Risk is commonly measured in volatility (daily, monthly, and yearly ups and downs) or maximum drawdowns. It's the pain you must withstand on the way to your returns.

We want the highest reward-to-risk ratio: the "optimal" portfolio.

The "optimal" portfolio tends to be a highly diversified mix of stocks, bonds, and alternatives (like gold, commodities, currencies, etc.). The diversity of assets means these portfolios are well-positioned for most economic environments. These portfolios have been dubbed "All-weather" or "All-terrain" strategies.

Economic environments and assets that perform well in each environment.

Although these portfolios have delivered excellent reward-for-risk, the "problem" is long-term returns are sometimes lower than more concentrated alternatives. Many investors desire greater returns than these "optimal" risk-reward portfolios are likely to provide.

To target higher returns, many investors choose to offload their diversifiers and concentrate into stock-heavy portfolios. But there's another option: levering the optimal risk-reward portfolio.

Concentration vs. Leverage

As an investor, you have two options if you want to increase your returns: concentration or leverage.

Efficient frontier comparing leverage to concentration.


Concentration is the strategy most people are familiar with: invest more heavily in stocks (i.e. concentrate into stocks) if you want higher returns.

But a major problem with stock-heavy portfolios is the drawdowns you must withstand. Stocks are known to suffer 20% to 40% declines every 10-20 years.

Historical drawdowns of the U.S. stock market from 1972 through April 2024.

Historical drawdowns of the U.S. Stock Market from 1972 through April 2024. Source: Portfolio Visualizer 

During these stock market corrections, it's challenging to stay calm and remain invested. Bad news surrounds us, the future is highly uncertain, unemployment is spiking, and so on. Making changes in these moments is all too common (and understandable) and leads to very poor outcomes (much worse than the long-term historical averages).


The alternative to concentration is leverage, or capital efficiency. Leverage is a tool to magnify the good and the bad of any investment.

Of course, leverage has plenty of its own, well-deserved, baggage. Leverage has been at the heart of many financial crises. However, leverage hasn't operated alone during these crises. It's been there with its partner, concentration. Examples include real estate during the global financial crisis, tech stocks during the Dotcom bubble, and hedge funds like Long-term Capital Management levering over 25-to-1.

A thoughtful application of leverage can increase your expected returns without exceeding the risks inherent to traditional, unlevered stock and bond allocations. In the graphic below, you can see how leverage allows a better trade-off between increased risk and return compared to concentration. The leveraged, or capital-efficient, portfolios (red dots) increase expected returns (moving up) commensurately with increased risk (moving right), while the 100% stocks portfolio flattens out the curve (a lot more risk for a little more expected return).

Efficient frontier comparing leverage to concentration.

Leverage allows investors to preserve the risk-reward benefits of a highly diversified portfolio to target higher returns.

Risk Parity + Capital Efficiency

Let's look at an example of Risk Parity + Capital Efficiency vs. traditional asset allocations.

Risk Parity vs. Traditional Portfolios

First, let's compare a simple risk parity-style portfolio to two common, traditional portfolios: a "balanced" 60% stock & 40% bond portfolio and a 100% stock portfolio.

The following portfolios were compared from January 2000 through March 2024:

  1. Simple Risk Parity: 30% Global stocks, 55% Treasury bonds, 7.5% gold, 7.5% trend-following
  2. "Balanced" 60/40: 60% Global stocks, 40% Treasury bonds
  3. Global Stocks: 100% Global stocks

Although the annual growth rate (CAGR) is lowest for the simple risk parity portfolio, its returns were generated with significantly lower risk. The simple risk parity portfolio experienced about half the volatility (Stdev) of a 60/40 portfolio and a third of the volatility of the global stock portfolio. The risk parity portfolio also only suffered a maximum drawdown of 12.7%, compared to 30.3% for the 60/40 portfolio and 54.0% for the stock portfolio.

Performance and risk comparison of risk parity investing, a 60/40 balanced portfolio, and stocks.

Source: PortfolioVisualizer

However, despite the better risk-adjusted returns of the risk parity-style portfolio, it still underperformed the traditional portfolios on an absolute basis (5.6% CAGR for risk parity vs. 6.1% for global stocks). The concentrated stock portfolio was the highest absolute performer. But what if an investor was willing to use risk parity + capital efficiency?

Risk Parity + Capital Efficiency

Now let's compare the same traditional portfolios to the simple risk parity portfolio levered up 1.5x.

The following portfolios were compared from January 2000 through March 2024:

  1. 1.5x Simple Risk Parity: 45% Global stocks, 82.5% Treasury bonds, 11.25% gold, 11.25% trend-following, -50% cash
  2. "Balanced" 60/40: 60% Global stocks, 40% Treasury bonds
  3. Global Stocks: 100% Global stocks

The 1.5x (capital-efficient) simple risk parity portfolio now outperforms the traditional asset allocations with less risk. The annual growth rate of 7.4% is achieved with lower volatility (standard deviation) and lower maximum drawdown than the 60/40 portfolio and global stock portfolio.

Performance and risk comparison of levered risk parity investing, a 60/40 balanced portfolio, and stocks.

Below is a comparison of the drawdowns experienced for each portfolio over the last 20+ years. Because leverage is applied to a conservative, balanced risk parity allocation, the drawdowns of the 1.5x Simple Risk Parity portfolio are less severe than traditional stock and bond allocations.

Drawdown comparison of levered risk parity investing, a 60/40 balanced portfolio, and stocks.

This example demonstrates the data behind the risk-return graphic we viewed earlier (and showcase again below). The 1.5x risk parity portfolio is similar to the second red dot along the dashed line, where you see a higher return than the traditional portfolios (white dots) with less risk.

Efficient frontier comparing leverage to concentration.

How do you "use leverage"?

The concept I've described thus far was introduced in 1952, when Harry Markowitz developed Modern Portfolio Theory (MPT). However, while institutions have put this theory into practice for decades, most individual investors are entirely unfamiliar with this concept.

This is because, until recently, this investment strategy has been impractical or impossible for individual investors.

A critical requirement to put this theory into practice is the ability to access cheap borrowing near the risk-free rate. If you are forced to pay exorbitant borrowing rates to achieve leverage, your portfolio's returns will not exceed the cost to borrow and the strategy simply doesn't work.

Prior to recent SEC rulings and the launch of several funds that embed leverage, individual investors were forced to use margin accounts to access leverage. Below are the current borrowing rates for individual investors to use margin (leverage) in personal trading accounts as of May 2024. These borrowing rates of nearly 12% or greater are over double the current risk-free rate of about 5%.

Margin rates at Schwab brokerage as of May 2024.

However, things changed in 2019 when the SEC adopted Rule 6c-11, the so-called "ETF Rule." The rule modernized the ETF framework and streamlined the regulatory process, clarifying rules for ETFs to provide complex strategies (such as employing leverage).

As a result of this ruling, ETFs were created which employ leverage using futures contracts, which have implicit borrowing costs of essentially the risk-free rate.

So individual investors can now use these ETFs to employ leverage with institutional borrowing costs instead of using portfolio margin. An additional benefit is investors are only exposed as far as their investment into these funds and are not subject to margin calls.

The following is a real-world example of a newly created ETF that allows investors to employ leverage.

Example of a Leveraged ETF

WisdomTree's U.S. Efficient Core Fund (NTSX) is an excellent example of how the SEC's ruling has changed the game for individual investors.

NTSX combines S&P 500 stocks and bond futures to effectively provide 1.5x leverage to a 60% stock and 40% bond portfolio. For every $1 invested, an investor essentially obtains 90% stock and 60% bond exposure.

This means an investor could invest 66.7% into NTSX and approximate a 60% stock (66.7% * 90%) and 40% bond (66.7% * 60%) portfolio, while still having 33.3% of their portfolio in cash. Below is a comparison of a 66.7% NTSX and 33.3% cash portfolio vs. a fully invested 60% S&P 500 stock (SPY) and 40% bond (GOVT) portfolio since NTSX's inception in 2018.

Performance comparison of a capital efficient portfolio to a fully-invested portfolio.

Comparison of 66.7% NTSX & 33.3% cash vs. 60% SPY (S&P 500 ETF) and 40% GOVT (Treasury Bond ETF) from September 2018 through April 2024, rebalanced monthly.

Products like NTSX offer individual investors access to institutional-level borrowing costs and thereby the ability to employ a capital-efficient investment approach.


All investors should start from the "optimal" portfolio, which generates the greatest return per unit of risk. If an investor desires a greater expected return, then they must choose between concentration or leverage.

Concentration is the traditional approach. And historically it has been the only viable approach for individual investors.

But in 2024 investors may choose leverage. And, as we have demonstrated, a thoughtful application of leverage to a highly diversified portfolio has the potential (and the theoretical backing) to increase expected returns without exceeding the risks of traditional portfolios.