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July 19, 2011
by Jack Reynolds

If you are guiding private wealth, a charitable trust or a private foundation then the tactical and strategic use of debt is relevant to you. Here are three compelling, and sometimes controversial, reasons for employing debt in your investment strategy:

1)      Securing a line of credit for cash flow management and periodic asset allocation rebalancing.

2)      Using the least costly debt to finance asset purchases, be they investment assets or not.

3)      Levering your portfolio strategically.

Securing a Line of Credit for Cash Flow Management & Periodic Asset Allocation Rebalancing

A line of credit can be invaluable, regardless of whether you are an individual, family, charitable trust or private foundation. You may scratch your head and wonder, “Why is a line of credit important when I have more cash on hand than I know what to do with?” This is a fair question and one I address below.

Most investors keep sufficient cash on hand to handle the following unpredictable circumstances:

  • Life style spending (or the operations of a charitable trust or private foundation).
  • Tax payments.
  • Capital calls for non-marketable alternative assets investments in venture capital, buyouts, natural resources, real estate and other funds.
  • Charitable gift or grant commitments.
  • Intra-family gifts.
  • Opportunistic or unscheduled asset acquisitions.

Having cash on hand to cover these circumstances is comforting.  However, cash generates little income, and generally has a negative real (after inflation) return.   In today’s low interest rate environment, cash is projected to have a negative real return for some time.   If you are holding cash then you should consider investing it in more productive investments that are under-weighted in your portfolio. Doing so will move you toward achieving your long-term strategic asset allocation targets.

Concurrently with investing your cash, consider establishing a line of credit larger than you can possibly imagine your cash needs to be for the next year. Why is a line of credit a prudent or responsible part of your balance sheet?  First, it is an alternative to using cash or liquidating an asset to pay the unpredictable circumstances listed above. Second, paying the line of credit down to roughly zero annually is an excellent opportunity to engage in asset class rebalancing.  Specifically, liquidate an over-weighted investment to pay down your line of credit, and rebalance your portfolio toward your long-term strategic goal. This approach offers you a convenient and simple way to use cash flow management to steer your portfolio toward its targets annually. It is entirely prudent and responsible.

The best time to secure a line of credit is when you have a lot of cash, which is also when you are likely to get the most favorable pricing and terms from your private banker. Your unused line of credit should cost you little or nothing, if you shop around.

Using the Least Costly Debt to Finance Asset Purchases

In thinking about asset purchases, I advocate making rational choices about your financing. If you are awash in low-earning cash then you may want to use cash for an asset purchase. In other instances, debt in the form of a mortgage, for example, can be attractive. That is especially true if you can pay your mortgage debt back over a number of years using an ever-depreciating currency, thanks to inflation.

I am not suggesting which asset(s) should be financed with debt. Rather, I am making the argument that if an asset is to be financed in part with debt, then you should use the least costly debt available. For example, using a mortgage for a primary home can offer tax advantages in some countries — effectively reducing the cost of the debt. The cost of mortgages on secondary and tertiary homes is typically less attractively priced and is seldom tax-subsidized. The cost of direct loans on machinery, equipment, vehicles, yachts and planes may not be appealing, unless the loans are aggressively subsidized by a manufacturer. Debt backed by investment securities may be meaningfully less costly than many of the foregoing loans secured by the asset(s) purchased.

I encourage you to investigate the least costly way to finance each asset purchase. Consider using investment assets as collateral, if that form of debt is the least costly financing for you. This is an area where an experienced private banker, working in concert with your Private Investment Counselor, attorney and accountant can help you make the best and most cost effective decisions.

Levering Your Portfolio Strategically with Debt

What do I mean by leverage? I mean borrowing money (from a bank, investment bank or broker) and using the debt to acquire more investment assets in your portfolio. This is called levering or gearing at the portfolio level.

Portfolio leverage can be controversial and some investors find it too risky or even imprudent. On the other hand, many very conservative investors use debt to lever their portfolios by investing in hedge funds, natural resources, mining, timber, commercial real estate and buyout funds. The use of debt is fundamental to all these investments. If you are considering using debt to lever your portfolio then the investment strategy questions are:

  • How much debt you should employ?
  • Should all decisions about debt be left to your individual asset managers, or should you use debt at the portfolio level for the purpose of increasing your investment exposure?

Debt can also be used as a tool to reduce portfolio risk. If, for example, you have a large, low cost basis, concentrated asset which you are reluctant to sell, and/or it has constrained liquidity, then you can use debt to diversify your portfolio without selling the asset. You can borrow against the so-called legacy holding and use the money to build a diversified, lower risk portfolio next to your legacy position. This approach is not for the faint of heart since: 1) the resulting portfolio retains the risk associated with the legacy holding, and 2) it has both the upside and downside risk associated with the newly acquired asset. If you choose to employ this approach then it should be done with care and attentive supervision on a continuing basis for risk management.

Your choices about the use of debt in your portfolio are strategic. Debt is one of the most important Opportunity Classes and deserves to be discussed candidly. If you read Harvard University’s Annual Financial Report (see 2009/2010 at p. 13) you will find that Harvard uses debt to lever its endowment.  Harvard’s use of debt was an adverse factor in its investment performance during the Financial Crisis of 2008 and 2009. On the other hand, Harvard’s use of debt was a positive factor in its stunning success over the decade or more going into the Financial Crisis.

The use of debt to lever a portfolio is not appropriate for everyone. Further, how much debt you use to lever your portfolio merits careful analysis. You should be thoughtful and open in exploring all Opportunity Classes with your Private Investment Counselor and investment committee.


The use of debt as a tool for cash management and periodic asset class rebalancing is almost a no-brainer. In this context, debt is a tactical tool which should be driven down roughly to zero annually.

Another tactical use of debt is for acquiring assets. Investment portfolio debt used in this way can be rational, low cost and prudent.

Finally, while it may be controversial, I propose that you and your investment team consider using debt as a strategy to lever your portfolio by increasing your exposure to investment assets and/or diversifying a large, concentrated, possibly low cost basis, and/or illiquid legacy holding. I do not advocate the use or avoidance of portfolio leverage for strategic purposes. Rather, I encourage you to make a knowing and thoughtful decision about its potential use.


Letter Regarding Manager Selection  

When I consider investing in a particular mutual fund I consider the fund’s performance, track record, firm’s reputation, type of investments, etc. I very rarely have direct access to the fund manager to evaluate the points you discuss.  However, when I select my portfolio manager, I meet with him personally and regularly to discuss my investments and make sure we are the same page regarding his investment philosophy and the points you discuss.  Lisa A. Maini, Founder & C.E.O. of myMarketingManager and an Advisory Board member of Reynolds Group, Private Investment Counselors™

Editor’s Comment

To appreciate the context of Lisa’s thoughtful letter, take a look at my e-Newsletter to which she refers, Manager Selection. It is common for an investor who wants, say, U.S. large cap equity exposure to turn to a mutual fund company, such as a Fidelity or Putnam, and to select a fund from their family of funds with the best fit for their portfolio.

I advocate an approach that is more client-centric. When I help a client select an asset manager I first select the portfolio management and research team, and then I help a client make a choice about the vehicle for expressing that selection, which can often be a mutual fund. If you have a Private Investment Counselor he/she will be completely independent of the mutual fund companies and will focus exclusively on finding the fund or manager best suited to your needs. If you enjoy doing your own research, consider services such as Morningstar and Value Line.  Either way, the most critical factor in selecting a mutual fund or a separate account manager is the investment team.