Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 2

Applying Leverage

In the last chapter, we introduced indexed investments and demonstrated how their built-in diversification can provide the ability to efficiently capture long-term returns but with lower volatility than individual securities. In this chapter, we will apply financial engineering and portfolio management techniques to create related investments, but with new risk and return profiles that allow us to achieve higher returns with less capital.

We begin with an in-depth explanation of the leverage ratio and its effects on risk and returns, and in the process show how even investments with negative equity still have value, and provide some guidelines for investors that can help them understand how much leverage is too much. Then, we introduce and compare several leveraged investment tools available to index investors, including margin, futures, and options.

The last portion of the chapter is devoted to leveraged portfolio management and reinvestment. Expertise in these areas can mean the difference between low volatility and high returns, or sky-high volatility and a fund collapse, and we encourage readers to study that portion carefully.

LEVERAGED INVESTMENTS: CONSERVATION OF RISK

The year is 1990, and Merton Miller has just won the Nobel Prize in Economics. At the awards ceremony, he gives a speech on corporate leverage.

At this time, “corporate leverage” is the dirtiest pair of words in finance. In the 1980s, financiers begin issuing junk bonds and taking ...