How being scared of leverage affects stock returns

(MoneyWatch) Several recent academic papers show that low-volatility stocks have had better risk-adjusted returns than high-volatility stocks. Basically, this would mean you can get about the same returns with less risk, which runs contrary to modern portfolio theory. Now there seems to be a rush to discover what is causing this apparent anomaly. One recent paper looked at the role leverage -- or more specifically, investors' natural aversion to leverage -- plays.

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The authors of the 2011 paper, "Leverage Aversion and Risk Parity," examined whether leverage constraints contribute to the anomaly. They note that Fischer Black's 1972 paper, "Capital Market Equilibrium With Restricted Borrowing," showed that if some investors are averse to leverage, assets with less exposure to stock market risk (or low-beta assets) will offer higher risk-adjusted returns, and vice versa.

Thus, an investor who is less leverage-averse (or less leverage constrained) than the average investor can benefit by overweighting low-beta assets, underweighting high-beta assets and applying some leverage to the resulting portfolio. (It's worth noting that basically this is the strategy Warren Buffett has typically followed -- using the leverage provided by his insurance company to buy low-beta companies -- and perhaps explains at least some of his outstanding results.)

The following is a summary of their conclusions:

• Leverage aversion changed the predictions of modern portfolio theory.
• Leverage aversion caused safer assets to offer higher risk-adjusted returns than riskier assets. To increase returns without using leverage, leveraged-constrained investors bought high beta assets, pushing their prices up and reducing their returns.
• Earning the higher risk-adjusted returns offered by safer assets required leverage, creating an opportunity for investors with the ability and willingness to borrow. For such investors, the market portfolio was no longer the most efficient portfolio.

The authors noted that introducing leverage creates risks. Thus, it's realistic to assume that some market participants are unable or unwilling to use leverage. "Leverage simply presents a risk that investors want to be compensated for bearing. Further, to obtain and manage leverage requires acquiring a certain 'technology.'"

Indeed, obtaining leverage requires getting financing, using derivatives and establishing counterparty relations. Managing leverage requires adjusting margin accounts and dynamic trading in the portfolio over time, among other things."

Some investors are prohibited from using leverage (such as endowments, pension plans and many mutual funds). And investors face margin requirements, limiting the amount of leverage that can be applied. Others must have some of their assets in cash (like an emergency account). For mutual funds, a need to hold cash creates an incentive to overweight high-beta securities to avoid lagging their benchmarks in a bull market because of the cash holdings. Because of these constraints, risk-seeking investors will overweight risky securities instead of using leverage.

As we've previously discussed, Wall Street has created low-beta funds to exploit the anomaly. However, before you invest, you should understand that there doesn't seem to really be anything unique about low-beta stocks. Further analysis reveals that low volatility strategies basically trade one risk (lowering exposure to the market factor, beta) for others (the incremental risks of value stocks and term risk present in bonds).

In other words, there's nothing novel with this approach that can't be replicated with traditional value-oriented stock and bond portfolios, using the bond portion to dampen the overall risk of the portfolio to an acceptable level.

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