Leverage is Not Bad Just Misunderstood

Australian advisors are keen to deliver the best outcomes for their clients, but the unintended consequences of regulation and compliance around investing mean that risk-adjusted returns in Australia let folks down.

Betting Against Beta Strategy

Research by Frazzini and Pedersen (2014) indeed provides compelling evidence for the effectiveness of the "betting against beta" (BAB) strategy. Their study found that a BAB factor, which is long leveraged low-beta assets and short high-beta assets, produces significant positive risk-adjusted returns. This strategy has shown promising results across various asset classes, including U.S. equities, international equity markets, Treasury bonds, corporate bonds, and futures.

Implications for Australian Financial Advice

The Australian financial advice industry's approach to leverage may be overly cautious. The BAB strategy challenges the conventional wisdom that higher risk necessarily leads to higher returns.

Potential Benefits of Leveraging Low-Risk Assets

• Higher risk-adjusted returns: By applying leverage to low-beta assets, investors may potentially achieve better risk-adjusted returns compared to simply investing in high-beta assets.
• Diversification: The BAB strategy can provide diversification benefits, as it has shown consistent returns across different markets and asset classes.
• Market inefficiency exploitation: The strategy takes advantage of the tendency for high-beta assets to be overpriced and low-beta assets to be underpriced.

Regulatory Approach and Its Consequences

APRA and ASIC's approach to leverage regulation raises concerns borne out of history:

• Overly restrictive policies: The current regulatory framework in Australia appears to focus heavily on limiting leverage, potentially overlooking its strategic use in portfolio construction.
• Impact on client outcomes: By restricting the use of leverage, regulators may inadvertently be limiting the potential for improved risk-adjusted returns for Australian investors.
• Narrow risk perspective: The regulatory approach seems to focus primarily on downside risk mitigation, potentially at the expense of optimising overall portfolio performance.

Compliance and Risk Management

Compliance fails to understand the full consequences of its actions, as its focus is not on client outcome:

1. Holistic risk assessment: Compliance frameworks should consider both the risks and potential benefits of leveraging strategies, rather than adopting a blanket avoidance approach.

2. Education and understanding: There may be a need for better education within the compliance and advisory sectors about advanced portfolio construction techniques, including the strategic use of leverage.

3. Client-centric approach: Risk management should be tailored to individual client circumstances and goals, rather than applying a one-size-fits-all approach to leverage.

In conclusion, while prudent risk management is crucial, an overly conservative approach to leverage may indeed be limiting the potential for improved risk-adjusted returns for Australian investors. A more nuanced understanding of leverage strategies, such as the BAB approach, could potentially lead to better outcomes for clients. However, it's important to note that implementing such strategies requires careful consideration of individual client circumstances, market conditions, and regulatory constraints.

Citations:

[1] https://research.cbs.dk/en/publications/betting-against-beta

[2] https://alphaarchitect.com/2022/04/betting-against-beta-new-insights/

[3] https://www.apra.gov.au/sites/default/files/draft_reporting_standard_ars_1101_leverage_ratio.pdf

[4] https://www.apra.gov.au/sites/default/files/Leverage%2520ratio%2520requirement%2520for%2520ADIs_0.pdf

[5] https://www.apra.gov.au/leverage-ratio-requirement-for-authorised-deposit-taking-institutions

[6] https://asic.gov.au/about-asic/news-centre/find-a-media-release/2020-releases/20-254mr-asic-product-intervention-order-strengthens-cfd-protections/

[7] https://asic.gov.au/about-asic/news-centre/find-a-media-release/2022-releases/22-082mr-asic-s-cfd-product-intervention-order-extended-for-five-years/

[8] https://www.sciencedirect.com/science/article/pii/S0304405X13002675