Friday, March 16, 2007

Leveraging Your Knowledge About Leverage

Part of my work is to identify points of view that help illuminate our very complex world. Here are two interesting and insightful excerpts for your consideration.

Rich Bernstein on correlations:
“Since we first wrote on this topic eleven months ago, the correlations between our select asset classes and stocks have changed noticeably. Those searching for noncorrelated assets should focus today on Bonds (both Treasuries and High Grade Corporates), T-Bills, Commodities, Gold and Consumer Staples.

Since the deflation of the Technology bubble, many investors have searched for assets that are “uncorrelated" to the S&P 500. These asset classes, like hedge funds, non-US stocks, and commodities, seemed in 2000 to not only provide significant diversification benefits, but also offered higher returns. The persistent low returns of this decade have caused some investors to use additional leverage to boost returns in these asset classes. The theory was the risks associated with the leverage were immaterial, when compared to the significant risk-reduction benefits of investing in "uncorrelated" assets.

Whereas that theory was true seven years ago, our analysis continues to show that 2000’s non-correlated asset classes are now often highly correlated to the S&P 500, and their diversification benefits now seem to be greatly reduced, if not completely eliminated. Investors should realize that higher returns again now simply require taking more risk as many opportunities have been bid away.”

Harry Markowitz on leverage:
“The unlevered investor cannot go any further than point (0,0), at which his return is maximized. If an unlevered investor tries to compete with a levered investor for returns, he can only access higher yielding, risky securities. As a consequence, the presence of leverage for some investors drives down the risk premium for ALL securities, including the riskiest securities with worse risk-reward profiles.”

Have a good weekend.

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