Just as leverage can be a risk magnifier, it can also be used defensively to enhance diversification and reduce portfolio vulnerability. The key distinction is that defensive leverage doesn’t concentrate risk—it spreads it across multiple, uncorrelated return streams.

One of the primary defensive uses of leverage is to maintain exposure to multiple asset classes without sacrificing return potential. For example, consider an investor who wants exposure to both equities and managed futures. Without leverage, they might have to split capital, allocating 50% to each. But with a modest amount of leverage, they could maintain full equity exposure while layering in a diversifying return stream. This return stacking approach allows investors to maintain broad diversification while targeting similar expected returns.

Institutional investors frequently use leverage not to make riskier bets but to achieve capital efficiency. For example, pension funds implementing liability-driven investing (LDI) often use levered duration positions to better align their fixed income exposure with long-term liabilities. By employing derivatives such as Treasury futures or interest rate swaps, they can extend duration without allocating all their capital to bonds, freeing up assets for return-seeking investments. This approach helps balance risk and return while maintaining a strong liability hedge.

Some strategies actively use leverage to hedge downside risks. Managed futures, for instance, often employ leverage to express long and short positions across various asset classes. By doing so, they can take advantage of market trends while maintaining low correlation to traditional equities.

Another example is levered risk-controlled portfolios, where a combination of assets is used to target a specific risk level. Instead of investing entirely in equities, an investor might apply leverage to a mix of lower-risk assets, such as bonds or defensive alternatives, to achieve equity-like returns with lower overall risk.

To illustrate the difference between reckless and defensive leverage, consider two portfolios:

The key difference is not the leverage itself but how it is applied. In the reckless case, leverage amplifies concentration and volatility, while in the defensive case, it enhances diversification and capital efficiency.

Leverage has long been painted as a villain in financial markets. However, as we’ve outlined, its risks arise primarily when paired with **illiquidity, concentration, and excessiveness** (LICE). On the other hand, when used defensively – to enhance diversification, improve capital efficiency, and manage risk – leverage can be a valuable tool.

Financial advisors should recognize that leverage is not inherently dangerous but should be employed thoughtfully. The real question is not “Is leverage bad?” but rather “How is leverage being used?” By understanding this distinction, investors can make more informed decisions and construct more resilient portfolios.