Don't Use Leverage to Diversify A Concentrated Stock Position
eps who recommend diversifying a concentrated stock position by borrowing against that position to buy additional stocks - a popular strategy promoted by major wirehouses — may want to reconsider that advice. A just-released study concludes "theoretically and empirically" that the strategy thought to reduce risk "predictably did exactly the opposite."
Craig McCann, Ph.D., CFA and Dengpan Luo, Ph.D., who operate a securities litigation-consulting firm in Virginia, conducted the study. One can access it at
www.slcg.com.
Notably, this study is one of several on the website worth examining (including a study determining that the popular exercise and hold strategy for employee stock options was misguided because there are few, if any, tax advantages, and that they do not outweigh the disadvantages associated with the resulting hold of a concentrated stock position).
The study, entitled, "The Use of Leveraged Investments to Diversify a Concentrated Position", is based upon a case study involving Home Depot stock as well as "extensive simulations." The researchers formed and studied the standard deviations of 7 million portfolios (1 million for each of 7 years, from 1997 through 2003). For each of the 100 stocks in the NASDAQ 100, they formed 10,000 value-weighted, 15 stock portfolios drawn randomly from the remaining 99 stocks in the NASDAQ 100. They also simulated the leveraged diversification strategy 1 million times in 2002 and 2003 by using portfolios comprised of 10, 25 and 50 stocks, but noted that the results did not differ materially. The researchers used the S&P 500 as a proxy for a fully diversified portfolio.
McCann and Luo begin by recognizing that the most prudent course of action is to eliminate the concentrated position by selling some or all of it to raise cash to buy additional stocks. Specifically, the researchers find that over the seven-year period from 1997 through 2003, reps could have reduced the average risk of the concentrated position by 70% had they fully (100%) diversified. Even selling one-half of the concentrated position would have reduced the risk by 45%.
Moreover, reps who implemented the leveraged diversification strategy caused portfolios to have "four or five times" the risk of a properly diversified portfolio. The leveraged diversification strategy even carried more risk than simply holding the concentrated stock position! Specifically, in 98.6% of the cases, the researchers find that fully leveraged portfolios were 44% riskier than the concentrated stock positions. Even partially leveraged portfolios were 26% riskier than the concentrated stock positions in 96.9% of the cases.
The only caveat relates to correlation. McCann and Luo concede that the leveraged diversification strategy increases the investor's risk unless the returns of the additional securities are "significantly negatively correlated" to the returns of the concentrated stock position. However, they state that this condition would not be satisfied if the additional securities bought were common stocks. Furthermore, the researchers note that, in practice, the securities bought were "quite similar." Indeed, "[o]ften, the strategy amounted to little more than making additional investments in the concentrated position on margin" (emphasis added).
Regarding the tremendous amount of additional risk caused by the leveraged diversification strategy, McCann and Luo note that the "dramatic result" is not a function of the date that they chose to start the analysis. In each year, the leveraged portfolios were "much more risky on average" than the concentrated stock position. For example, 1998 was the most favorable year for the leveraged diversification strategy, yet even in that year, the strategy increased risk in 96.5% of the cases.
In the "rare cases" in which the leveraged diversification strategy reduced risk, McCann and Luo conclude that the expected return of the leveraged portfolio was "much less" ("dramatically" so) than the expected return of the concentrated position.
Additionally, the researchers find that margin calls were the "predictable result" of the leveraged diversification strategy. Of course, investors often were faced with margin calls as the value of the concentrated stock position as well as the value of additional stocks decreased. In 2000, the study shows that investor's equity fell to 25% in 56% of the simulated fully leveraged portfolios. In 94% of the instances in which the investor would have received a margin call, the value of the investor's concentrated position exceeded the net equity in the leveraged investment. Thus, "when a margin call would have been issued the investor would have almost always been better off not having leveraged up the concentrated position."
In conclusion, reps should understand that their firm's promotion of the leveraged diversification strategy has been shown - at least according to this study - to be ill advised, to the extent that "the cure is worse than the disease." Reps should seek contrary authority justifying the use of this strategy before they recommend it to their customers.
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