Leveraging an Investment Portfolio - Not a Free Lunch!

The Financial Times (FT) recently published an article highlighting that 8 large US pension plans with assets totalling circa $1.5trn are embarking on the use of leverage (or borrowing) in their investment strategies. The article brings to life once again the issue of how leverage is not a free lunch and the need to carefully assess the risks that leverage introduces. This was starkly illustrated by what happened to UK Defined Benefit plans during the LDI crisis of late 2022.

From the FT “At least eight very large US public pension funds are using borrowed cash or other leverage strategies, now that the board of Calstrs, one of the largest US retirement funds, this month voted to allow the fund to borrow as much as $30bn, or 10 per cent of its portfolio.”

Of note, this leverage appears to be being taken on in the presence of significant investments to illiquid assets. As an example the article also states that “Virginia has almost half of its portfolio in private markets, including a 33 per cent stake in private equity, according to 2023 data.”

One major issue that arose from the UK LDI crisis was the degree of leverage going into the crisis, combined with market movements to create a rapid fall in LDI fund values (by definition, the fall in values was magnified by the degree of leverage in LDI funds). Thus as gilt yields rose, collateral of unexpected large scale and higher than expected frequency was called by leveraged LDI funds, this required timely action from Trustees and managers to source liquidity from other parts of the portfolio to remain in the market. Not all plans could deliver the cash on time, and some LDI funds basically ran out of funds and so some plans were forced to cut risk.

The issue with leveraging a significantly illquid portfolio, is by definition those illiquid assets are not readily available for sale, and so not able to be converted to cash at short notice (such as that required by an unexpected, large collateral call).

Before rushing to judge the situation, the finer details are important however. The article does not indicate whether Virginia is targeting an allocation of around 50% of its assets in illiquids, or whether 50% of the plan assets is the degree of the plan’s maximum commitment to private assets which may take many years from today to ladder into. In determining the right degree of leverage to take on, it is important to account for the size and expected timing of the projected

cashflows to and from illiquid assets.

Whilst these US large pension plans are using leverage as part of their long-term strategic asset allocation to maximize returns while balancing risk, the implementation should be carefully considered, aligning the return and diversification potential with a proper assessment of the risks, especially the question of what could happen if risky asset values fall and additional cash is required to fund the leveraged position.

At Synthesis Enterprise Solutions, we are well versed with helping clients navigate the question of the balance between leverage and illiquidity in meeting client risk and return parameters.

Reference - "US Pension Funds worth £1.5tn add risk through leverage", FT https://www.ft.com/content/623b67f9-090c-457f-a327-dc9f767e327a