By Morgan Stanley
Leverage can significantly expand the range of portfolio choices. However, in practice, multiple
constraints exist that limit the use of leverage, the nature of the assets that can be leveraged, and the acceptable levels of total portfolio and asset-specific risks.
Such constraints may force the available efficient frontier to shrink to a surprisingly narrow set of
portfolios — ones that fall along a single, modestly sloped line located in the middle of the risk/return space.
Any form of leverage is also subject to a number of special concerns: vulnerability to changing financing costs, unanticipated capital calls, illiquidity spirals, etc.
On the one hand, the perceived advantages of leverage can induce a temptation for excessive
risk-taking. On the other hand, one must be sensitive to the fact that pragmatic issues and cautionary
concerns may keep many funds from even considering the use of leverage. In all cases, it can be enlightening — even for funds that are currently prohibited from using leverage — to envision how other investors that do use leverage can influence the common investment landscape.
We thank Dr Stanley Kogelman, who is a consultant (not a member of Morgan Stanley’s Research department), for his
important contributions to the development of the mathematics and the research in this report. (Unless otherwise indicated, his views are his own and may differ from the views of the Morgan Stanley Research department and from the views of others within Morgan Stanley).
To continue reading 'Limits of Leverage' please download the PDF below.
|
