|
 Gross, a bond manager with an enviable long-term track record, comes
to a somewhat jarring conclusion in his most recent investment
outlook.
After having first rehearsed the diminishing returns to the economy,
and markets, from what he calls “credit based oxygen” and
forecasting a future period of low returns, Gross goes on to argue
for the use of the very same leverage to goose, as it were,
individual portfolio returns.
“The successful portfolio manager for the next 35 years will be one
that refocuses on the possibility of periodic negative annual
returns and minuscule Sharpe ratios and who employs defensive
choices that can be mildly levered to exceed cash returns, if only
by 300 to 400 basis points,” he writes.
Gross recently called 10-year German bunds, then changing hands at
about a yield of 10 basis points, the “short of a lifetime.” Bund
yields have since shot up to 59 basis points but it is unclear how,
or if, Gross and his funds managed to profit on the move.
Still, there is something here that doesn’t sit well.
Many investors are concerned, for good reason, that future returns
in major asset classes will be poor.
Fund manager GMO’s 7-year forecasts show negative annual real
returns in five of seven major equity segments and in four of five
major bond markets. This compares with a historical U.S. equity
return of inflation plus 6.5 percentage points.
In other words, that 8.0 percent annual return target so many
pension funds and individuals pencil in may need to be erased.
Equity markets look toppy. Just ask Janet Yellen who on Wednesday
called valuations “quite high” saying they embed “potential
dangers.”
Bond markets are if anything a worse bet. Just ask Bill Gross.
Yields are at multi-generation or all-time lows and showing, as
Yellen helpfully added “reach for yield type behavior.”
Deciding that leverage, even small amounts and always, according to
the manager doing it, used judiciously, is the answer feels like a
recipe for dialing up the risk just because you have become
accustomed to the rewards.
LEVERAGE EVERYWHERE
There is ample evidence that investors are turning increasingly to
leverage.
FINRA’s 4000 securities firm members report that their clients are
carrying a record $518 billion in margin debt. New York Stock
exchange data also shows record margin debt, and a 2.5 percent
growth in the month of March alone.
Also consider the rise of so-called risk parity strategies among
pension funds. Risk parity, used by hedge fund firm Bridgewater
among others, uses leverage to boost the returns of the bond portion
of a given fund, sometimes by making larger bets on bonds and
sometimes by investing in other asset classes. Some estimates put
the amount dedicated to risk parity strategies at more than $200
billion.
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Finally consider pension obligation bonds, a growing tactic used by
states and localities who want to pay the pensions they owe but want
to avoid tax rises or service cuts.
The idea is that you pay 4.0 or so percent in interest and get to
keep the “extra” you can earn by putting that money to work in the
market.
Even better, some of the pension funds borrowing money to invest are
then investing in leveraged hedge funds or other vehicles, piling
leverage upon leverage.
Colorado last week passed a bill to issue up to $10 billion in
pension obligation bonds for the $45 billion Colorado Public
Employees' Retirement Association.
The problem, which perhaps some savvy or lucky investors will avoid,
is that leverage increases risk and increases the chances that an
investor will be forced to sell at exactly the wrong moment.
Hedge funds have been shown to take on more leverage at perhaps
exactly the wrong moment, when market values are high and funding
costs low, according to a 2011 academic study.
But Douglas Tengdin, chief investment officer of $1.6 billion wealth
management firm Charter Trust Company in New Hampshire sees little
appetite for debt-enhanced returns among his institutional clients.
“The trustees widely have chosen not to leverage because leverage
kills,” Tengdin said. “They are increasingly limiting leverage even
in the instruments they use.”
Of course leverage, used well, can and does work. But when it works
badly, it works not at all, and can lead to the permanent loss of
capital. The risks of a 100 percent gain followed by a 100 percent
loss are not symmetrical.
A rise in leveraged investing just at a time of low expected returns
seems a dangerous combination.
(James Saft is a Reuters columnist. The opinions expressed are his
own)
(James Saft)
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