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Generating Alpha With Leverage

Can equity tactical investing generate alpha without any leverage? The answer is that this is rare phenomenon. As a result, use of leverage is widespread and due to this practice come some extremes cases.

Commodity futures traders know alpha comes from the leverage of the contracts and that there is a direct relationship between leverage and risk of ruin; as leverage increases, so is risk of ruin. It was CTAs in the 80s that came up with the principles of practical risk and money management.

As futures trading lost popularity to stock trading in the late 90s, some traders and hedge funds managers have since attempted to replicate the high leverage potential of futures trading in the equities markets using borrowed money. In fact, some mathematicians have attempted to even determine the amount of leverage for optimal equity growth. I will not go into details because in my opinion these methods are highly overrated and in some respect reckless or even naïve applications of mathematics to a difficult subject. These “optimal” methods suffer from serious shortcomings in dealing with the non-stationary nature of market price series but have been elevated to discoveries due to a single reason: greed.

The blind application of optimal leverage determination methods because they look mathematically sound without paying attention to assumptions can lead to ruin during times of high volatility. Recently we learnt a fund was 10x leveraged and had invested in some known momentum stocks. When the uptrend in one of these stocks ended and a sharp decline followed due to fundamental reasons, the high leverage position generated a margin call and that led to a chain reaction of margin calls that eventually ruined the fund and also caused losses to some of the parties involved in providing the leverage to the fund. This is greed reflected in leverage and often justified with the use of obscured and naïve math.

Is it possible for unleveraged strategies in the equity markets to generate alpha and in addition superior risk-adjusted returns when compared to buying and holding S&P 500 index, for example?

Although some funds may succeed it is very hard to reject the null hypothesis the outperformance was realized by chance. This is because given a large distribution of fund managers, some may outperform the market consistently by chance alone. I am quite surprised when I see articles in financial media and social media posts from people who are supposed to understand the market and who are baffled by the fact that the majority of fund managers underperform benchmarks. Of course the majority will underperform by virtue of zero-sum game and distribution of returns. Anyone who is surprised about this fact maybe should try playing with a Monte Carlo simulator. But why are then investors giving money to hedge funds? There is a simple answer for that: diversification.

Here is a specific example familiar to most. Let us consider the well-known 12-month moving average tactical investing strategy in S&P 500. The strategy goes long when price is above the 12-month moving averages and exits if it drops below. We will compare buy and hold performance to strategy with no leverage, 2x and 5x leverage. Test period is 01/1940 to 03/2021.

The passive investor (gray line) transition to tactical investing of this kind does not appear to be worth the effort. Although equity curve volatility drops from 15.5% to 11.1%, there is a slight drop in annualized return. Without leverage, the strategy generates slightly better risk-adjusted returns but nothing to get excited about.

With 2x leverage, things are getting interesting. Annualized return rises to about 13% versus about 8% for buy and hold. However, volatility rises to 19.1%. There is alpha but it comes at higher risk, as expected, and risk-adjusted returns are not better than when using no leverage. In fact, Sharpe for 2x leverage is 0.68 as compared to 0.67 without leverage. There is gain but only based on perspective.

Why then not going for 5x leverage? Large investment banks are willing to offer money for collateral. Now things start become interesting: annualized return surges to 23% but also volatility surges to 37%. Maximum drawdown is 67.4% versus 56.8% for buying and holding. If someone is greedy, this is the choice.

Some people justify the greed based on assumption of a bull market continuing with no major correction that will cause a large drawdown. However, if the simulations are done, risk of ruin probability for 5x leverage is close to 1 given time. Some may think they will be out of the market before ruin because they are intelligent enough to realize when that will happen. This thinking makes ruin the certain event.

Needless to say that for 10x leverage the strategy hits 100% drawdown and this happens after an exponential rise in equity. Does this sound familiar based on recent events related to an actual fund? High leverage is how someone can become very rich and then very poor. Obviously, most get very poor before they have a chance to become very rich but there are exceptions due to luck. Ruin is certain if someone uses the formula for optimal leverage found in some finance and trading books written by people with little or no skin in the game. Or maybe anti-skin in the game.

Without leverage alpha is very difficult although not impossible when there is significant edge. With leverage, the trade-off between risk and return start to factor in. If greed dominates, ruin is certain. The difference between 8% and 20% annualized return is substantial and impacts growth of AUM. Some of the investors may not care if they lose 1% to 5% of the allocation in exchange for potential 100% returns on it in a few years. But the fund manager may lose everything; the AUM and the reputation for essentially a gamble that target wealth will be hit before a large drawdown. This is how gamblers in casinos think and there is a certain dimension of recreational speculation there but in markets losses can do a lot of damage.


Disclaimer:  No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

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