The Decision to Lever
نویسندگان
چکیده
We provide an exact performance attribution for levered strategies. The attribution includes some familiar elements: return magnification due to leverage, borrowing costs, trading costs, and the variance drag; while familiar, these elements are sometimes downplayed in backtests of levered strategies. In addition, we find empirically that the covariance between return of the source portfolio and leverage plays an important role in determining the cumulative return of levered strategies. This covariance is highly unstable over horizons of three to five years. In our examples, risk parity levered to the volatility of a traditional 60/40 portfolio, and bonds levered to the volatility of stocks, the covariances were negative over our 84-year horizon (1929–2012); as a consequence, fixed-leverage versions outperformed the volatility-targeting versions of those strategies. We find no evidence that traditional fully-invested strategies such as 60/40 underperformed risk parity strategies with comparable volatility. Key terms: Leverage; source portfolio; trading cost; magnified source return; excess borrowing return; risk parity; pension fund; fixed leverage; dynamic leverage; volatility target ∗Department of Economics, 530 Evans Hall #3880, University of California, Berkeley, CA 94720-3880, USA, email: [email protected]. †Department of Economics, 530 Evans Hall #3880, University of California, Berkeley, CA 94720-3880, USA, email: [email protected]. ‡Department of Statistics, University of California, Berkeley, CA 94720-3880, USA, email: [email protected]. §This research was supported by the Center for Risk Management Research at the University of California, Berkeley. We are grateful to Patrice Boucher, Claude Erb, Ralph Goldsticker, Nick Gunther, Barton Waring and two anonymous referees for insightful comments on the material discussed in this article.
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