More discussion on returns, risk and leverage

Previously I discussed an important debate on whether it is better to increase a portfolio's return by taking on more risks (e.g. holding high-beta stocks), or by increasing leverage but holding low-risk assets. A reader Mr. F. Sudirga has kindly send me some other research papers supporting the conclusion that increasing leverage is the preferred way.

In a paper titled "Risk Parity Portfolios", Dr. Edward Qian at PanAgora Asset Management argued that a typical 60-40 asset allocation between stocks and bonds is not optimal because it is overweighted with risky assets (stocks in this case). Instead, to achieve a higher Sharpe ratio while maintaining the same risk level as the 60-40 portfolio, Dr. Qian recommended a 23-77 allocation while leveraging the entire portfolio by 1.8. The stock-bond dichotomy is for illustration only -- the results can be improved further by including other asset classes such as commodities.

The only reservation I have with all this enthusiasm with increasing leverage is one that many risk-managers are aware of: most of the research uses concepts such as standard deviations to measure risk. But as the LTCM debacle as well as the recent subprime mortgage meltdown has reminded us, risky events have fat-tailed distributions. Therefore, one should be very wary of using standard deviation as the sole determinant of leverage.