Market Sense and Nonsense: How the Markets Really Work (and How They Don't)

Chapter 15

The Leverage Fallacy

Leverage can be dangerous. There is no shortage of hedge funds that have collapsed as a result of excessive leverage, with Long-Term Capital Management, detailed in Chapter 13, being the classic example. Investors have learned the lesson that leverage is dangerous rather than leverage can be dangerous. In this sense, they are much like the cat that sits on a hot stove. As Mark Twain observed, “She will never sit down on a hot stove-lid again—and that is well; but also she will never sit down on a cold one any more.”

Investors always seem to ask hedge funds the question: “How much leverage do you use?” This question is flawed on two fundamental grounds. First, the question is meaningless, given that it ignores units of measurement: the underlying investment (that is, what is being leveraged). Second, it implicitly assumes that there is a direct connection between leverage and risk. Not only is this assumption false, but it is even possible—in fact, entirely common—for a higher-leverage investment to have lower risk.

Consider a comparison between two fixed income funds that are approximately equivalent in terms of credit risk, liquidity, and other relevant risk factors with the exception of exposure to interest rate changes. Assume Fund A’s portfolio is unleveraged and has a net duration of 10 years, while Fund B’s portfolio is leveraged 5:1 and has a net duration of one year. (Duration is the approximate multiple by which a bond’s price will change, ...