Finding the right amount of leverage for your portfolio

How leverage can be the best option to enhance returns and achieve your goals

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Investors have been very fortunate in recent years. Especially in the US, stocks and bonds have both delivered solid returns, in part fueled by decades of falling interest rates and rising valuations. Going forward, the UBS Chief Investment Office (CIO) expects these tailwinds to fade, resulting in an environment of lower returns over the next few market cycles.

Fortunately, investors have options for improving returns while still managing risks. Click the speaker icons throughout this interactive experience to hear CIO analysts discuss how diversification—and the prudent use of borrowing strategies—can help to solve the quandary of lower returns.

Forward-looking returns are likely to be lower, but diversification can help

Realized returns from 2010–⁠2020, forward-looking return expectations, and return contributions by asset class
 

Source: MorningstarDirect, UBS, as of February 2021. Risk-adjusted return is calculated by dividing annualized return by annualized risk (the standard deviation of returns). Expected return is based on UBS Equilibrium Capital Market Assumptions for the Moderately Aggressive Strategic Asset Allocation for taxable investors, without nontraditional asset classes.
Note: The 60% stocks, 40% bonds portfolio is invested only in US equities and US intermediate-term government bonds. The moderate portfolio is globally diversified, including corporate bonds, emerging market stocks, and small- and mid-cap stocks. 

 

Why consider borrowing now?

Borrowing costs

Borrowing costs are near all-time lows

3-month London Interbank Offered Rate (Libor), with forecasts through 2040
 

Source: Bloomberg, UBS, as of 21 April 2021

Even before the global recession sparked by COVID-19, interest rates were already near record lows. Today, on the heels of unprecedented levels of monetary stimulus, investors have the opportunity to lock in some of the lowest borrowing costs in history.

With an equally unprecedented amount of fiscal stimulus also entering the economy—and COVID-19 vaccines allowing for life to begin returning to normal—we expect the current bull market to enjoy solid returns in the years to come.

Fixed-rate loans

With short-term rates set to rise, fixed-rate loans look attractive

Current market projection of forward interest rates
 

Source: Bloomberg, UBS, as of 21 April 2021

With interest rates set to rise as a result of the economic expansion, it may be prudent to borrow using a fixed-rate loan. Fixed-rate loans often come with a slightly higher borrowing cost than a floating-rate loan, but can help to provide certainty on your interest expense as market conditions change.

 

Potential advantages of applying leverage

Diversification has been called "the only free lunch in investing" because it can allow investors to manage the portfolio's volatility, achieving a higher level of expected return per unit of expected risk.

Adding leverage to a diversified portfolio can allow investors to achieve similar (and in some cases potentially higher) expected returns as if they simply added to stocks and other risk assets, but with a higher expected risk-adjusted return than shifting to a higher allocation in stocks.

With superior risk-adjusted return potential, leveraged diversified portfolios can produce greater and more consistent portfolio growth potential than portfolios that seek to increase expected returns by sacrificing diversification to increase the allocation to stocks.

Beyond a point, adding to equities increases portfolio risk more than it increases portfolio return

Historical returns, standard deviations, and return/risk ratios for stock/bond portfolios, from 1945 to today
 

Source: Morningstar Direct, UBS as of February 2021. Illustration shows portfolios comprised of US large-cap stocks and intermediate US government bonds.

 

Why keep an allocation to bonds?

When it comes to implementing portfolio leverage, our primary goal is to enhance after-tax portfolio growth while maintaining diversification.

Despite low interest rates and yields in today's market, bonds play a critical role as a portfolio diversifier. Because interest rates tend to fall (and bond prices rise) during bear markets and other bouts of market volatility, high-quality bonds have the potential to reduce portfolio volatility more than they reduce portfolio return. During bear market environments, interest rates tend to fall and bond prices rise; bonds can therefore provide a "safe haven" during these difficult periods that play an essential role in a portfolio.

With these factors in mind, keeping a healthy allocation to bonds in a well-diversified portfolio and then applying leverage can help an investor achieve several objectives:

More return potential

Adjusting portfolio leverage can often be done without the need to sell assets and realize capital gains taxes (a potential cost of changing an unleveraged portfolio's asset allocation).

Smoother returns

Keeping the assets invested in a well-diversified asset allocation can result in the smoother compounding of returns, and can mitigate the duration of drawdowns and recovery times.

Better risk-adjusted returns

When compared to simply adding to stocks and other risk assets, leveraged portfolios can provide the potential for higher returns and more return per unit of risk.

 

Finding the right amount of leverage for your portfolio

Expected impact

Prudent leverage may improve returns more than adding to risk assets

Expected risk and return after various borrowing costs and amounts of leverage
 

Source: UBS. Expected return and volatility are based on UBS Equilibrium Capital Market Assumptions, for Strategic Asset Allocations for taxable investors without nontraditional asset classes.

When compared to the unleveraged portfolios, leveraged portfolios can offer a superior expected return and risk-adjusted return as long as the future returns of the portfolio exceed the financing costs.

For example, a borrowing cost of 3.25% both significantly enhances expected returns and results in a more “efficient” (offering a higher return per unit of risk) portfolio than re-positioning an allocation to the next risk portfolio without leverage. As borrowing costs decrease, we would expect both the return enhancement and the “efficiency” opportunity of using leverage to be greater.

Maximum leverage

Keeping a prudent level of leverage helps to avoid margin calls while enhancing growth during recovery rallies and bull markets

Historical drawdowns from the global financial crisis, the worst drawdown in modern history, and portfolio returns during the recovery (from trough until the next all-time high)
 

Source: UBS. This historical analysis uses daily returns on indices that correspond to each broad asset class, and assumes a loan cost of Libor + 2.75%.
Past performance is not indicative of future results. Your performance may vary based on implementation and asset allocation differences.

To implement leverage, you must borrow funds to add to your investment assets. One way to implement this is to tap into a securities-backed credit line, which uses your investment assets as collateral for the loan.

In order to take advantage of the potential benefits of portfolio leverage, it's vital to take steps to avoid margin calls. In the event of a large drawdown, a margin call could result in the forced sale of the leveraged assets, which would lock in losses and challenge a portfolio's ability to participate in a subsequent market recovery with the same proportion as the fall.

The maximum leverage recommendations we outline in this report were calibrated to maintain a significant buffer from a margin call during the worst drawdown since the great depression, the 2008 Global Financial Crisis.

Implementation

Applying portfolio leverage in practice

Illustration of implementing portfolio leverage
 

Source: UBS. These example Strategic Asset Allocations do not include nontraditional asset classes. UBS does not provide tax advice, so please consult a tax professional when considering how to structure your investment portfolio and borrowing strategy.

One advantage of applying leverage is that it allows you to increase your portfolio's growth potential without needing to realize capital gains and pay taxes, as might occur with an asset allocation change. Instead, you borrow from your current assets and use the loan proceeds to increase your invested assets.

The primary goal of implementing portfolio leverage is to enhance after-tax portfolio growth while maintaining diversification. If structured correctly, it may be possible to deduct the interest cost of your portfolio loan from the taxes that you owe on your investment returns.
 

 

Explore the impact of leverage on your portfolio
For illustrative purposes only

Warning: The proposed portfolio leverage exceeds the maximum recommended leverage threshold for the risk profile you've chosen. We would generally advise against taking on this level of portfolio leverage unless you have a dependable source of outside assets or financing that can be relied upon even in the worst market environments—and even then, you should only proceed after careful consideration with your financial advisor.

In our report, we determined a maximum recommended leverage for each risk profile. This threshold is calibrated to maintain a significant buffer from a margin call, based on our analysis of historical drawdowns and margin call thresholds in scenarios where investors employed leverage at the worst possible time, i.e. at a market peak right before a drawdown. For each risk profile, any portfolio leverage above the maximum recommended leverage ratio would have resulted in a margin call during the global financial crisis (the worst drawdown since the great depression). Investors should be very cautious about exceeding this threshold, only doing so when there is a dependable source of outside assets or financing that can be relied upon even in the worst market environments. Staying under the maximum recommended leverage threshold does not guarantee that any individual investor or strategy will avoid potential margin calls, especially if you plan to purchase less-liquid investments.

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See portfolio details
In %
In $
Performance Indicator
Expected Return*
Expected Volatility
Return/Risk
Asset ClassCurrent AllocationFinanced AllocationTotal Allocation
Cash
US Government FI Short
US Government FI Intermediate
US Government FI Long
US TIPS
US MBS
CMBS (US FI FIID)
Municipal Bonds
IG Credit
High Yield Bonds
Senior Loans
Preferreds
Emerging Markets Fixed Income (Blend)
US Large Cap Equity Growth
US Large Cap Equity Value
US Mid Cap Equity
US Small Cap Equity
Int'l Developed Markets Equity Core
Emerging Market Equity
Multi Strategy Hedge Funds
Private Equity
Private Real Estate
Total Allocation
Performance Indicator
Expected Return
Annual Loan Cost
Expected Net Return*
Asset ClassCurrent AllocationFinanced AllocationTotal Allocation
Cash
US Government FI Short
US Government FI Intermediate
US Government FI Long
US TIPS
US MBS
CMBS (US FI FIID)
Municipal Bonds
IG Credit
High Yield Bonds
Senior Loans
Preferreds
Emerging Markets Fixed Income (Blend)
US Large Cap Equity Growth
US Large Cap Equity Value
US Mid Cap Equity
US Small Cap Equity
Int'l Developed Markets Equity Core
Emerging Market Equity
Multi Strategy Hedge Funds
Private Equity
Private Real Estate
Total Allocation

*Leveraged portfolio return removes the loan cost.
Source: UBS. Expected return and volatility are based on UBS Equilibrium Capital Market Assumptions and Strategic Asset Allocations, published 27 April 2020. To preserve the potential for interest deductibility, the municipal bonds in the original portfolio should be held in a separate account that is not used as collateral for the loan, and the loan proceeds should not be used to purchase municipal bonds. UBS does not provide tax advice, so please consult a tax professional when considering how to structure your investment portfolio and borrowing strategy.
IMPORTANT: The projections or other information generated by this tool regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.

Back to portfolio inputs
 

How borrowing can help you achieve your goals

Many investors dislike taking on debt, but it can often be the best option available. To help make this assessment, we recommend that you consider borrowing strategies through the lens of the UBS Wealth Way, which can help you to determine the best solution for meeting your family's unique objectives.

We see four main reasons to consider portfolio leverage:

  1. To provide a "bridge loan" or secure liquidity
  2. To increase diversification
  3. To increase return potential
  4. To mitigate taxes

The UBS Wealth Way framework can help to judge whether a particular borrowing strategy's potential rewards outweigh its costs and risks to result in better outcomes or a higher likelihood of successfully meeting your goals. We recommend using the Liquidity. Longevity. Legacy. framework to build a purpose-built investment approach (including portfolio loans and other borrowing resources) across three strategies:

For more on this subject, please see our previous report, How borrowing can help you meet your goals.

UBS Wealth Way disclaimer
UBS Wealth Way is an approach incorporating Liquidity. Longevity. Legacy. strategies that UBS Financial Services Inc. and our Financial Advisors can use to assist clients in exploring and pursuing their wealth management needs and goals over different timeframes. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment. Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability.

 

 

Borrowing to finance spending

Borrowing can help you keep your portfolio invested for growth

Portfolio growth, in USD, assuming 6.67% p.a. investment return and 2.25% borrowing cost, following a 1-year investment period

 

 

Option #1: Taxes from portfolio

Option #1: Taxes from portfolio

Option #2: Taxes from loan

Option #2: Taxes from loan

 

Initial portfolio

Initial portfolio

Option #1: Taxes from portfolio

3,000,000

Option #2: Taxes from loan

3,000,000

 

Credit line

Credit line

Option #1: Taxes from portfolio

0

Option #2: Taxes from loan

350,000

 

Tax payment

Tax payment

Option #1: Taxes from portfolio

(350,000)

Option #2: Taxes from loan

(350,000)

 

Remaining portfolio value

Remaining portfolio value

Option #1: Taxes from portfolio

2,650,000

Option #2: Taxes from loan

3,000,000

 

Return on portfolio

Return on portfolio

Option #1: Taxes from portfolio

176,695

Option #2: Taxes from loan

200,032

 

Annual loan cost

Annual loan cost

Option #1: Taxes from portfolio

-

Option #2: Taxes from loan

(7,875)

 

Net investment return

Net investment return

Option #1: Taxes from portfolio

176,695

Option #2: Taxes from loan

192,157

 

Total value added

Total value added

Option #1: Taxes from portfolio

 

Option #2: Taxes from loan

+15,462

Source: UBS. Expected return is based on UBS Equilibrium Capital Market Assumptions for the Moderately Aggressive Strategic Asset Allocation for taxable investors, without nontraditional asset classes.

We often recommend that investors consider setting aside borrowing capacity to finance spending, either as an alternative to setting aside large cash holdings that offer limited interest income, or as an alternative to selling investment assets that have greater return potential.

In this table, we show a case study of how borrowing to fund spending can improve returns. In this example, Mark has USD 3,000,000 invested in a Moderately Aggressive portfolio (roughly 70% stocks and 30% bonds). He needs to make a USD 350,000 tax payment, and can choose to raise funds either by liquidating a part of his portfolio, or by tapping into his securities-backed credit line at an interest rate of 2.25%.

As shown in the table, Mark could have approximately USD 15,462 more in his account if he borrows to make the tax payment, and if markets provide an average return over the next year. This analysis doesn't include the impact of realizing capital gains taxes, which could further enhance the value of borrowing, especially if Mark has another source of income to pay down the loan balance. 

 

How to effectively manage leverage

Loan-to-value ratio

Like any loan, there is a maximum amount that you can borrow off of a securities-backed credit line, determined by the expected risk of the securities that you own in the accounts you've pledged as collateral. For example, you may be able to borrow 50% of the asset value of a stock, 70% of the value for a high-yield bond fund, and 90% for a US Treasury fund. These ratios are known as "release rates."

Your credit line approval amount will reflect the weighted average of the release rates and market value of each of the holdings in the accounts that you have pledged as collateral for the loan. If you have more invested in low-risk securities, your credit line approval amount will be higher than if you have a portfolio of high-risk investments, all things being equal.

When you take out a securities-backed loan, the bank will keep an eye on your loan-to-value (LTV) ratio to make sure that your loan doesn't exceed the LTV associated with your approved credit line balance. If your portfolio goes higher, your LTV ratio will fall and your approval amount will rise; if the portfolio falls, your LTV ratio will rise and your approval amount will fall.

If your portfolio's LTV rises above the level approved by the bank, you could be subject to a "margin call," which may require you to add assets to your account or sell investments to pay down the credit line balance. This means that it's important not to draw your entire approval amount from the loan unless you have other resources to pay down the balance.

Rebalancing your loan

One advantage of securities-backed credit lines—as opposed to some other types of debt—is that you can usually pay down the loan balance, or draw additional capital from the credit line, without incurring a transaction cost.

We expect that most investment portfolios will grow faster than the cost of borrowing, most of the time. As a result, it’s likely that your LTV ratio will gradually decline over time. If you wish to maintain a consistent LTV ratio, which may help you to boost your long-term expected returns, you can draw additional assets from your loan and add them to your investment account over time. It’s important that you do not rebalance your portfolio to an LTV that exceeds your portfolio’s maximum recommended leverage ratio, because this could result in a higher risk of margin calls.

 

Next steps

    1. Speak with your financial advisor about your borrowing capacity and the interest rate available for a securities-backed credit line tied to your portfolio.
    2. If you are planning to tap into your borrowing capacity, ask your financial advisor whether a fixed-rate loan makes sense for you.
    3. Speak with your tax advisor about whether you could deduct the interest on an investment loan from your taxable investment income.
    4. Consider whether borrowing might help you fund your spending without realizing capital gains taxes, keeping your portfolio generating growth and income.
    5. When seeking a higher return, consider portfolio leverage as an alternative to shifting your allocation from bonds to stocks and other risk assets. 

    Note on municipal bond expected returns
    Please note that, throughout this report, we have made a “taxable-equivalent” adjustment to expected returns for municipal bonds. Municipal bond income isn’t subject to federal income taxes, so we have adjusted our equilibrium Capital Market Assumptions for municipal bonds to reflect this benefit, assuming that investors will be subject to the 37% top marginal tax rate for taxable income. This adjustment changes our expected return for municipal bonds from 2.8% pre-tax to 4.4% taxable-equivalent, and affects each portfolio proportional to its municipal bond allocation. Therefore the portfolio returns are estimates on a pre-tax basis.

    CIO research disclaimer

    About the authors

    Portrait of Daniel Scansaroli, Ph.D.

    Daniel Scansaroli, Ph.D.

    Head of CIO Portfolio Strategy & UBS Wealth Way Solutions, UBS Global Wealth Management

    Daniel Scansaroli is a Managing Director and Head Americas Portfolio Strategy & UBS Wealth Way Solutions for the UBS Chief Investment Office. Dan advises individuals and institutions on asset allocation, goals-based investing, and portfolio/risk management. He also leads the intellectual capital offering for Wealth Way and the Ultra High Net Worth business.

    Dr. Scansaroli joined UBS from BlueMountain Capital Management, where he was the Head of Portfolio Construction & Modeling and a Managing Portfolio Strategist responsible for leading the investment process, sizing frameworks, modeling, and risk management for all multi-strategy funds. As part of the CIO’s Fund Management Committee, he was responsible for strategy and execution of tailored asset allocations, and dynamic hedging programs to manage factor exposures in accordance with institutional client risk and return mandates.

    Previously, Dan was Head of Quantitative Research & Strategy for the J.P. Morgan Private Bank Chief Investment Office. His team was responsible for managing & evaluating discretionary portfolios, asset allocation, quantitative investment strategy, implementation guidance, and researching/developing multi-asset investment strategies to enhance performance and execute risk efficient portfolios. Dan specialized in customized wealth and portfolio solutions for UHNW Private Clients & Advisors. In his function, Dan was a member of JPM’s Capital Market Assumptions Committee and the CIO’s Investment Council which was responsible for managing all discretionary model portfolios, including strategic asset allocation, tactical investment shifts, and risk/return analysis.

    Dan joined J.P. Morgan from Lehigh University’s USD 1bn+ Endowment where he was responsible for portfolio construction, risk management, manager due diligence, and performance/investment analysis. Dan has also worked as a lead Process Management Consultant, and as an Analyst at Rothschild’s M&A and Restructuring division.

    Dan holds several degrees from Lehigh University, including a doctorate (Ph.D.) in Industrial/Financial Engineering, a M.S. in Applied Mathematics, a M.S. in Management Science, and a B.S. in Mechanical Engineering. He is also an Industry Advisory Council member for Lehigh University’s Master in Financial Engineering Program.

    Portrait of Justin Waring

    Justin Waring

    Investment Strategist, UBS Global Wealth Management
     

    Justin Waring is an Investment Strategist in the Chief Investment Office where he advises investors on global investment strategy, asset allocation, and portfolio construction.

    Justin joined UBS in 2008. Prior to joining CIO in 2016, Justin worked in the UBS Private Wealth Management office in Washington, DC, advising clients on investment strategy and spearheading portfolio and account management.

    Justin is an Accredited Portfolio Management Advisor (APMA). He is also a member of Omicron Delta Epsilon, the international economics honor society. He holds NASD Series 7 and 66 licenses. Justin earned a BS in Economics and a BA in International Affairs from The George Washington University.

    Portrait of Leslie Falconio

    Leslie Falconio

    Senior Fixed Income Strategist, UBS Global Wealth Management
     

    Leslie Falconio is a senior fixed income strategist and works on the US Fixed Income Asset Allocation recommendations. Leslie has more than 20 years as a fixed income portfolio manager. She began her career as a fixed income analyst, then as a portfolio manager at Metlife where she was responsible for Metlife's USD 20 billion intermediate fixed income portfolio. After Metlife, Leslie was the lead manager of Oppenheimer Funds' main US fixed income portfolios where one of the funds she managed, the Oppenheimer Intermediate US fund, was recognized in the Wall Street Journal as a top performing fund.

    Leslie also spent over seven years working as a hedge fund portfolio manager at Soros Fund Management and Graham Capital Management. She holds an undergraduate degree in Finance and Computer Science from the State University of New York at Buffalo. She has a Master of Business degree in Finance and Corporate Accounting for the University of Rochester, William E. Simon School of Business.

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