Institutional investors can employ leverage to increase expected returns. This increase in expected returns must be balanced against an increased risk of loss. Large institutional investors with a long-term investment horizon and ample liquidity are well-positioned to utilize leverage to safely increase expected returns.
What is leverage?
Expected returns can always be increased by borrowing money at an interest rate below the expected return on the assets being leveraged. In a world with no asset price volatility and no risk of permanent loss, adding leverage would be a “free lunch”.
Of course, the investment world does not work like that. Assets can have:
- Significant asset price volatility – e.g. diversified equity indices;
- Risk of permanent loss due to idiosyncratic risk – e.g. a large office building or private company;
- Low volatility and risk of loss, but also a low expected return relative to the cost of leverage – e.g. a bond portfolio
Institutional investors already utilize a significant amount of indirect leverage via their equity, real estate, hedge fund, and private equity investments, as company executives and fund managers seek to increase their returns by prudently using leverage. But relatively few institutions utilize meaningful direct leverage at the portfolio level. Adding direct leverage is a tool that more institutional investors should consider, although it also requires careful risk analysis and stakeholder education.
The increase in expected returns from the use of leverage is dependent on assumptions. The cost of leverage is known (e.g. 4% per year), but the return on the levered asset is unknown. The larger the spread between the return on the levered asset and the cost of leverage, the more the expected return will increase. Leverage can be obtained by borrowing from the sponsoring institution (e.g. a university or government agency), the portfolio (e.g. the endowment or pension fund), or against specific assets and held within the portfolio (e.g. swaps or futures or loans against hedge funds or private equity portfolios).
How can you obtain leverage?
Generally speaking, it is less expensive to borrow at the institution or total portfolio level than at the asset or asset-class level. Also, generally speaking, it is best to obtain the desired leverage in the least expensive way possible. However, many institutions have heavy restrictions or outright prohibitions on direct borrowing. For such institutions, there are three ways to obtain leverage:
- Invest in leveraged funds – this can be private equity or hedge funds, but also more traditional funds and ETFs that use borrowings or derivatives to add leverage to try and increase returns;
- Place assets, such as fund units, in a special purpose vehicle (SPV) and borrow against those assets;
- Utilize derivatives such as swaps, futures, or options to gain synthetic exposure to specific assets, which can have the same economic effect as traditional borrowing and investing in those specific assets.
Most large institutional investors already invest in leveraged funds of some type. However, the degree of overall leverage that an investor can obtain is often limited by asset class restrictions specified in the Investment Policy Statement (IPS), e.g. a maximum of 15% in private equity. The degree of leverage can also be difficult to control as the underlying managers will usually have significant discretion as to when and how to employ leverage.
The use of SPVs is relatively common among large institutions, though their purpose is often to provide liquidity as opposed to increasing portfolio-level leverage. For example, an institution may have several mature private equity or other illiquid asset funds. These funds will liquidate over time, but maybe not at the pace that the institution desires. The investor can put these units into an SPV and then borrow against them, thereby obtaining cash that can be redeployed into new investments with higher expected returns. The same concept can be used to boost overall portfolio leverage and expected returns, but the cost of these structures is relatively expensive and there is also a significant amount of legal work that must be done to set them up.
Finally, institutions can use derivatives to obtain portfolio-level leverage in what can be a highly efficient manner. For example, an institution can increase its exposure to a major equity index such as the S&P 500 or MSCI World instantly via the use of futures or total return swaps. The implied financing cost for most major equity indices will be close to the Secured Overnight Financing Rate (SOFR), which is the cost to borrow on a collateralized basis. So long as equities are expected to outperform risk-free cash (plus any spread/transaction cost), then portfolio-level expected returns will increase. The SOFR rate will be at or near the lowest possible rate that any institution can borrow at, though it is “floating” and therefore can change quickly depending on the actions of the Federal Reserve.
The primary risk of using leverage in this way is a potential increase in volatility. Also, as these trades are collateralized, the institution must have collateral (either cash or Treasuries) already available and unencumbered or be able to source such collateral quickly if required. Most institutions do not hold large amounts of cash, but many do have significant Treasury holdings within their investment grade bond portfolios. These Treasuries can do “double duty” – they can be held for their economic exposure within the bond portfolio and can also be posted as collateral if required to back equity exposure. The degree to which there are sufficient Treasuries to back a derivatives-based equity exposure in this way will vary by institution and prudent implementation requires careful analysis. There is no “free lunch” – additional exposure to risky assets like equities can result in losses. But if an institution has a sufficient amount of collateral to weather an extremely large equity market downturn (e.g. 50%+), and if the increase in portfolio volatility is tolerable, then this can be an efficient way to increase overall expected returns.
Take a large pension fund as an example. The fund has an allocation to investment grade bonds of 30% (with 50% of these being Treasuries or equivalents), a regular equity allocation of 40%, and allocations to private equity/credit of 20% and hedge funds of 10%. The fund’s expected returns are:
The fund would like to work its assets harder but cannot invest more in illiquid assets due to liquidity constraints in the IPS. The fund instead adds 15% exposure to equities using total return swaps. Portfolio-level exposure is now 115% of the physical asset value – the fund is leveraged by 15%. The new expected returns are:
Expected returns have increased by 0.5% by adding a 15% exposure to the difference between equity expected returns and the cost of financing (assumed to be 3.5% in this example).
Risk has also increased but, for some institutions, the benefit of the higher expected return will offset the increased volatility and any concerns about having sufficient collateral. In this example, the fund has a total allocation of 15% Treasuries so a 15% allocation to synthetic equity means that equities would need to decline to zero before the available collateral pool would be exhausted. Institutions will generally have tighter risk controls than this when using leverage. But the point remains that the primary cause of failure of leveraged investment programs is an inability to maintain the trade when the asset being leveraged falls significantly and increasing amounts of collateral are required to be posted. If there is sufficient collateral to withstand a very significant downturn, and the institution is not affected badly by short or even medium-term volatility (perhaps due to asset/liability smoothing mechanisms), then adding cost-effective exposure in this way can look quite prudent.
There are many ways for institutions to utilize leverage in their portfolios. Each has positive and negative attributes and institutional investors are encouraged to work through these in light of their specific circumstances. If leverage is to be employed, spending the time to determine the most efficient way to obtain it is a worthwhile endeavor.