Traditional Optimization Is Not Optimal for
Leverage-Averse Investors

Abstract

Leverage entails a unique set of risks, such as margin calls, which can force investors to liquidate securities at adverse prices. Investors often seek to mitigate these risks by using a leverage constraint in conventional mean-variance portfolio optimization. Mean-variance optimization is unable to identify the portfolio offering the highest utility, however, because it provides the investor with little guidance as to where to set the leverage constraint. An alternative approach—the mean-variance-leverage optimization model—lets the leverage-averse investor determine the optimal leverage level (and thus the highest-utility portfolio) by balancing the portfolio’s expected return against the portfolio’s volatility risk and its leverage risk.

TOPICS: Portfolio theory, volatility measures, statistical methods