Investment Banking Principles: An Inside Look at Leveraged Investing and Risk Parity
By Austin J. Matt–
Forethought
Leveraged investing encompasses a tier of strategies utilized by investment banks for many years. It is the “black powder” used in portfolios managed by individual investors and institutions alike.
Investment Banks’ “Black Powder”
The world of investment banking is home to a plethora of strategies that all aim at the primary goals of banks: providing higher returns and building value at an increased rate over time. One strategy most commonly employed by investment banks and individuals, as a metaphorical “accelerant,” is leveraged investing. Leveraged investing is the principle of assuming debt or using loaned money to purchase investments. The benefit of this strategy is simple. Levering your investment allows you to put down less capital for an investment of equal value, while simultaneously recognizing the same returns as you would have; have you funded the entire investment yourself, before interest expenses (tax deductible). Undoubtedly this investment strategy’s effectiveness relies upon current interest rates. Assuming interest rates are equitable, and lending practices are orderly, a properly levered investment will yield a higher return on investment than it would have if it had not been levered. This is because after paying modest interest payments, the investor realizes a comparable and sizable return, having only put down a fraction of the original capital required. Simply put, less capital required for the same investment, yielding indistinguishable profit, leads to a higher return on the investment.
Every Source of Light Casts a Shadow
Unfortunately, as we often learn in the world of investing, every reward has its risks. In terms of leveraged investing, we realize the risk of increased losses along with increased gains. Unlike your average investment, in a levered investment, the investor runs the risk of the losing the value of the investment, and unlike the latter, still owes the principle and interest on the loan. In other words, where there is always light there is dark. Options must be weighed before any investor assumes the increased risks of leveraging an investment.
Think Smarter, Not Harder
Investment banks have given light to a more recent strategy in the world of leveraged investing, and they are calling it risk parity. Upon its conception, risk parity was compared to other strategies commonly used by hedge funds and other risk-measured investment vehicles. As more managers have begun to employ this strategy it has become discernible that risk parity is unlike many strategies employed by hedge funds, rather it is seemingly more analogous to strategies exploited by conservative wealth managers. The idea is that managers build a traditional portfolio based upon the needs and expectations of their clients. Capital is responsibly allocated amongst asset classes; free of any leveraging or “margin trading”. Traditionally a manager will begin with a traditionally allocated portfolio, 60% stocks and 40% fixed income or bonds, and depending upon the investor’s expectations and ability to assume risk, he or she will then concentrate capital into sectors believed to be undervalued. Managers believe this concentration to be an unnecessary risk. Risk parity; however, buys the less risky, fixed income investments, on the margin (levered) the re-allocates the remaining capital amongst sectors targeted for potential growth. Consequently, the portfolio is no-less diversified in regards to asset classes as before; however, the sectors believed to show potential signs of growth are concentrated more-so than others. Less risky, fixed income investments are leveraged to allow more capital to be positioned for higher returns, allowing the investor to maintain his or her position on the asset.
Smarter Investing: Is Risk Parity Worth the Risk?
Risk parity, as it seems, is not the “volatile” strategy hedge funds have been employing at all. Rather, risk parity is a strategic method of managing a portfolio with a moderately-conservative to conservative risk tolerance. In my opinion, this strategy is better defined as a management plan based upon a much more efficient “investment-capital utilization” structure.
BBA/MBA Accounting
Cameron School of Business, The University of St. Thomas, 2016