Is Increasing Beta Or Increasing Leverage A Amend Fashion To Growth Returns?

In my previous post, I reported an sharp observation from my reader Mr. Goldstein that maximizing chemical compound charge per unit of measurement of return, maximizing leverage, as well as maximizing Sharpe ratio are all tightly connected. This makes intuitive feel because the higher the Sharpe ratio of a strategy, the smaller the drawdown, as well as so the higher the leverage yous tin apply to it inwards guild to maximize chemical compound return.

Mr. Goldstein also made closed to other rattling interesting observation. He noted that in that location are unremarkably ii ways to growth the returns of a portfolio of stocks: either yesteryear picking high-beta stocks, or yesteryear increasing the leverage of the portfolio. In both cases, nosotros are taking on to a greater extent than adventure inwards guild to generate to a greater extent than returns. But are these ii ways equal? Or is 1 improve than the other? It turns out that in that location is some research out in that location which suggests increasing leverage is the improve way, due to the fact that the marketplace seems to hold upwardly chronically under-pricing high-beta stocks. This gives ascent to a strategy called "Beta Arbitrage": purchase low-beta stocks, curt high-beta stocks, as well as earn a positive return.

I myself receive got non studied this shape of arbitrage inwards depth, as well as so tin neither endorse nor criticize it. However, if this question is correct, it does debate against including equally good many volatile stocks inwards your portfolio or trading strategy. If yous desire to accept on to a greater extent than adventure as well as generate higher return, but plough the knob as well as growth your leverage as well as so mass size.

More Give-And-Take On Returns, Opportunity Together With Leverage

Previously I discussed an of import debate on whether it is amend to growth a portfolio's provide past times taking on to a greater extent than risks (e.g. belongings high-beta stocks), or past times increasing leverage precisely belongings low-risk assets. H5N1 reader Mr. F. Sudirga has kindly mail me another interrogation papers supporting the decision that increasing leverage is the preferred way.

In a newspaper titled "Risk Parity Portfolios", MD Edward Qian at PanAgora Asset Management argued that a typical 60-40 property resources allotment betwixt stocks as well as bonds is non optimal because it is overweighted amongst risky assets (stocks inwards this case). Instead, to laissez passer on a higher Sharpe ratio land maintaining the same endangerment score equally the 60-40 portfolio, MD Qian recommended a 23-77 resources allotment land leveraging the entire portfolio past times 1.8. The stock-bond dichotomy is for example alone -- the results tin live on improved farther past times including other property classes such equally commodities.

The alone reservation I accept amongst all this enthusiasm amongst increasing leverage is i that many risk-managers are aware of: virtually of the interrogation uses concepts such equally measure deviations to mensurate risk. But equally the LTCM debacle also equally the recent subprime mortgage meltdown has reminded us, risky events accept fat-tailed distributions. Therefore, i should live on really wary of using measure difference equally the sole determinant of leverage.