60/40 vs Leveraged Diversified Portfolio

Leverage can cut both ways

August 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Leverage is usually a destructive feature in investment products
  • However, using leverage with diversified portfolios can help achieve specific investment objectives
  • Bonds are not necessarily needed in asset allocation when considering alternatives

INTRODUCTION

When CalPERS announced in November 2021 that it would use a modest amount of leverage to boost its private equity exposure, the move drew sharp criticism from some investors who viewed it as excessively risky.

Yet, many of those same investors are eager to gain access to large multi-strategy hedge funds like Millennium and Citadel, which routinely use 5x to 10x leverage. So why does this form of leverage raise fewer concerns?

The key distinction lies in the nature of the underlying strategies. Private equity is still equity – leveraging it amplifies returns, but also directional risk. It’s a concentrated bet. In contrast, multi-strategy hedge funds diversify across numerous uncorrelated alpha streams, where the failure of one strategy has limited impact on the whole.

In short, leverage can magnify gains – or losses. In this article, we explore how it can be used effectively to pursue specific investment objectives.

60/40 vs LEVERAGED DIVERSIFIED PORTFOLIO: SAME VOLATILITY

We construct a diversified portfolio using a range of alternative strategies, including: AQR Managed Futures Strategy Fund (AQMIX), Vanguard Market Neutral Fund (VMNIX), BlackRock Global Equity Market Neutral Fund (BDMIX), AQR Diversified Arbitrage Fund (ADAIX), Eaton Vance Global Macro Absolute Return Fund (EGRIX), AGF U.S. Market Neutral Anti-Beta Fund (BTAL), and SPDR Gold Shares (GLD) (read Myth Busting: Alts’ Uncorrelated Returns Diversify Portfolios). We also allow the S&P 500 and U.S. investment-grade bonds to be used in the optimization process.

To ensure a fair comparison with a traditional 60/40 portfolio (comprised of U.S. equities and investment-grade bonds), we target the same level of volatility. The portfolio is rebalanced monthly and employs 1.5x leverage, with the cost of l