Protected Leveraged Investing
March 19, 2013
Fears of market overvaluation lead many advisors to seek to protect against downside movements while retaining as much upside potential as possible. Recent research from Boston-based money manager Grantham Mayo van Otterloo (GMO) illustrates a low-cost way to accomplish this: decreasing equity exposure and concentrating that allocation in high-beta securities.
It is well documented that low-beta stocks have historically outperformed high-beta stocks, both on an absolute and risk-adjusted basis. Given this outperformance, why would investors choose allocations to high-beta? A 2011 research paper by GMO explains why some investors would be well served by investing in high-beta asset classes.
Holding high-beta portfolios does not necessarily expose investors to greater risk, as I will argue. First, let’s review beta and the key findings of GMO’s research.
The capital asset pricing model, a foundation of modern financial theory, says that a security comes with kinds of risk: systematic and unsystematic. Systematic risk measures the extent to which the movement of a security’s price is correlated with that of an index. This market-related risk is measured by beta. Unsystematic risk is that which market movements cannot explain.
The higher the beta, the more volatile the security. A beta of 1.00 indicates that a security moves in tandem with an index. A security with a beta of 2.0 moves twice as far as the market in either direction. A security with a beta of 0.5 increases or decreases half as much when the market moves up or down. Among equities, certain sectors, like utilities, have low beta, while others, such as small-capitalization, technology and emerging-market stocks, have high beta.
A high-beta investment is analogous to a leveraged position in the market index. To increase exposure to the S&P 500, there are four choices: use margin; buy a leveraged fund; buy high-beta assets or buy call options on the index. The GMO study used a series of clever tests to demonstrate that the relationships between leverage, beta and call options are consistent.
The authors demonstrate that low-beta stocks provide returns similar to those generated by selling covered call options against a stock market index. That strategy caps returns, but the investor bears all of the downside risk of the stock index. Low-beta stocks have historically delivered higher returns than holding the index, but investors need to be willing and able to ride out the worst down markets.
Conversely, high-beta stocks are similar to buying call options on the stock market. Exposure to the market’s upside is amplified, but downside exposure is increased, due to the cost of the option premium.
The novel finding in the GMO study was that high-beta stocks provide “leverage with protection.” It is possible to create a portfolio with upside exposure in a rising stock market that mutes the downside risk.
This is not a free lunch. Average returns are lower, reflecting the cost of the downside protection.
Consider an investor with 60% in an S&P 500 fund (SPY, for example) and 40% in an aggregate bond fund (AGG). Alternatively, that investor could put 40% into an equity portfolio with beta of 1.50 and 60% in bonds. Both portfolios have the same “equity beta”: the allocation to equities multiplied by the beta of the equity portion of the portfolio. In the first case, the equity beta is 0.60: a 60% allocation to equities times a beta of 1.00. In the second case, it is also 0.60: a 40% equity allocation times a beta of 1.50. While beta and total risk (volatility) are not identical, we can design these two portfolios so they have exactly the same total risk levels. These two portfolios can be referred to as “risk equivalent.”
Which is better – the traditional 60/40 portfolio or the 40/60 portfolio that owns high-beta stocks? The appeal of the high-beta portfolio is that, in the event of a catastrophic loss in the equity market, it will not lose more than 40%, while the 60/40 portfolio could lose as much as 60%. On the other hand, in a rising stock market, both portfolios should gain the same amount, because their betas are identical.
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