LEVERAGE, HEDGE FUNDS AND RISK

Frank Barbarino, CAIA

Consultant, Hedge Funds

Executive Summary the hedge fund balance sheet without having a

great deal of conviction in the underlying in-
The current market environment has led inves- vestment ideas.
tors to reexamine the components of their in-
vestment programs, particularly in light of the  There are many ways for funds to obtain lever-
impact of the credit crisis and its accompanying age, each of which offer unique attributes with
elevated market volatility. Hedge funds repre- respect to term, stability, cost, and availability.
sent an investment category that has experi- The amount of leverage used by hedge funds
enced significant challenges, yet we feel they can vary substantially, dictated by the strategy
remain an important component of the invest- being utilized and several other variables.
ment structure for many long-term investors1. A
key element when evaluating hedge funds is to  Analyzing hedge fund balance sheets can help
assess the use of borrowed capital, or leverage, an investor understand how difficult market
as a part of their investment strategies and the circumstances can affect funds differently,
contribution of leverage to expected return and with some funds able to weather such environ-
risk. This topic is especially important given the ments while others suffer greatly or even go
investment climate of late, characterized by con- out of business.
strained availability of leverage and higher bor- While the hedge fund community’s access to
rowing costs, and the contribution of leverage to and use of leverage is evolving, we believe that it
certain fund blowups in the recent past. continues to represent a valid tool in the hedge
Key takeaways from this paper include: fund manager’s toolbox and that managers with
better access to it may benefit. Furthermore,
 Leverage should be an important considera- while the use of leverage has in many cases aug-
tion in the evaluation of hedge fund managers. mented the ability of certain managers and
While leverage generally amplifies both return strategies to generate attractive returns, we do
and risk, higher leverage does not always indi- not believe that in most cases access to leverage
cate higher risk, as it must be understood in is a prerequisite to alpha generation within the
the context of other features of an investment hedge fund space.
strategy.
A. How Leverage Works
 We do not believe that it is prudent to use
leverage to magnify the returns of a low-return We define financial leverage as the level of gross
position or strategy, or to increase the size of assets greater than equity capital invested. Lev-

1
For a general assessment of hedge funds in the current environment please see our recent research note: “Hedge Funds: Broken or Dam-
aged?”

The author would like to thank those individuals at NEPC who provided assistance and encouragement throughout the process of writing this
paper as well as those outside of the firm who provided their insights, with a special thanks to professionals from Robeco Sage.

Summer 2009
erage allows for the magnification of the return, B. Leverage in Hedge Funds...The Basics
and the risk, of the original equity investment.
Leverage exists throughout the economy and fi- Hedge funds utilize leverage in a similar fashion to
nancial markets. In the case of a company, issuing the way a bank, the buyer of a house, or a stock
additional debt rather than equity has the effect investor might. As seen above, leverage clearly
of amplifying the impact of revenue growth on decreases an investor’s margin for error. That is,
EPS. Here are a couple instances of this. when a relatively small amount of capital controls
a large amount of assets, the losses that can be
 A bank provides a common example of a com- sustained from those assets before the manager’s
pany that issues debt, often representing a mul- capital becomes impaired can be small. There-
tiple of more than ten times tangible book eq- fore, the greater the leverage, the less asset price
uity. Before the current crisis, banks felt confi- volatility the manager will be able to endure. The
dent doing so because they believed that their incentive structure and competitive environment
mix of assets had relatively low volatility (more of hedge funds sometimes leads managers to
on this idea later). shoot for a high return while ignoring the risk as-
sociated with achieving that return. This is a rea-
 The purchase of a house usually involves lever- son that manager selection in hedge funds, par-
age. An equity investment of, say, $100k (20%) ticularly those who use material levels of leverage,
and a loan of $400k (80%) to buy a $500k is so critical.
house, represents a four times (“4x”) leveraged
purchase (Debt/Equity). The past few years are filled with examples of
hedge funds using leverage to amplify the return
 Individual investors can also apply the princi- of securities with relatively low yields, or trades
ples of financial leverage to their investment with modest expected returns. Indeed, if the re-
portfolios. A margin account allows an investor turns that are achievable for a manager’s style
to borrow against the value of the securities decrease, some managers may be tempted to in-
and cash held in the account, effectively lever- crease leverage to make up the difference. One
aging the return and risk of those securities example of this phenomenon is that of hedge
100% or 1x (known as the “Reg T” limit). funds investing in bank loans throughout 2007
Let’s look at the math behind how leverage im- and 2008. Bank loans have historically been rela-
pacts an investment (see Table 1). tively stable investments, mainly because they sit

In the case of rising Table 1. The impact of leverage on investment returns

asset prices, one can Asset Prices Rise
see that leverage has a Leverage (Debt/Equity) 1.0x 2.0x
dramatically positive Equity $ 1,000,000 $ 1,000,000
effect on the return on Debt $ 1,000,000 $ 2,000,000
$ 2,000,000 $ 3,000,000
equity (ROE), amplify- Assets
Return on Assets (ROA) 10% 10%
ing a return on assets Gross Profit/Loss (P&L) $ 200,000 $ 300,000
(ROA) of 10% to an Cost of Leverage (at risk-free rate of 2%) $ (20,000) $ (40,000)
ROE of 26% when 2x Net Profit/Loss (P&L) $ 180,000 $ 260,000
leverage (Debt/Equity) Return on Equity (ROE) 18% 26%
is used. However, with
a -10% ROA, 2x lever- Asset Prices Fall
Leverage (Debt/Equity) 1.0x 2.0x
age has a very nega- Equity $ 1,000,000 $ 1,000,000
tive impact, with a - Debt $ 1,000,000 $ 2,000,000
34% result in ROE. Assets $ 2,000,000 $ 3,000,000
These examples illus- Return on Assets (ROA) -10% -10%
Gross Profit/Loss (P&L) $ (200,000) $ (300,000)
trate the importance Cost of Leverage (at risk-free rate of 2%) $ (20,000) $ (40,000)
of handling leverage Net Profit/Loss (P&L) $ (220,000) $ (340,000)
with care. Return on Equity (ROE) -22% -34%

2 Leverage, Hedge Funds and Risk

toward the top of the corporate capital structure great deal of conviction in his positions. Investor
and are secured by assets of the company. They skill and experience are required in order to dis-
have historically had low levels of default, and, in tinguish between these two scenarios.
cases in which defaults did occur, high recovery
rates. In recent years these loans traded at very The level of leverage used by a hedge fund can-
narrow yield spreads as demand from Collateral- not be observed in isolation as an indicator of the
ized Loan Obligations (or “CLOs”, a leveraged riskiness of that fund or its underlying strategies.
structure that buys bank loans), hedge funds Understanding the details of each manager’s trad-
(using leverage facilities called total return swaps, ing style, the return drivers of the strategies im-
or TRS, more on those later), and other leveraged plemented, and the construction of the portfolio
market participants bid up prices. The tighter are essential to the evaluation of a manager’s lev-
spreads became, the more leverage was applied erage and risk profile. We attempt to determine
an appropriate leverage level based on the strate-
gies and sub-strategies employed, and based on
THE PAST FEW YEARS ARE FILLED WITH our experience of what levels of leverage a man-
ager should be utilizing in their portfolios given
EXAMPLES OF HEDGE FUNDS USING such a strategy.
LEVERAGE TO AMPLIFY THE RETURN OF
The “riskiness” of leverage depends on what posi-
SECURITIES WITH RELATIVELY LOW
tions are being leveraged. When assets that are
YIELDS, OR TRADES WITH MODEST expected to move in conjunction instead diverge,
EXPECTED RETURNS. this is a notion called “basis risk”. This is the risk
that two assets behave differently to one another
and lose money at the same time. For example, if
in order to make yields attractive to investors. a manager applies leverage to a position consist-
The rest of the story is history, as they say, with ing of two very similar securities, one long and
investors in CLOs, hedge funds, and other lever- one short (e.g. Long Nike stock, Short Reebok
aged vehicles losing money in bank loans begin- stock), this is much less risky than applying that
ning in the summer of 2007 as spreads widened same level of leverage to a position consisting of
with more and more market participants attempt- two dissimilar securities (Long Exxon stock, Short
ing to sell. JetBlue stock). This is because the price of the
similar assets will tend to move in tandem, with
We view strategies that are dependent on signifi- the gains on one offsetting the losses on the
cant leverage in order to generate adequate re- other.
turns as generally less attractive. This is more
true in today’s environment, because leverage is Table 2. Hedge funds and Basis Risk
not as easy to obtain as it was in the past. Con-
versely, due to the broad selloff of risky assets, in
many cases less leverage is currently needed in
order to obtain attractive returns. Certain hedge High Use caution Dangerous
fund strategies do employ moderate leverage,
and many well-implemented strategies can have
good portfolio diversification effects and attrac- Basis
tive risk/return dynamics. Generally, we are com- Risk
fortable if a manager is using leverage in order to
amplify the return of a compelling position or Low Acceptable Use caution
strategy or if the manager is seeing many high po-
tential return opportunities.

In contrast, however, we feel it is imprudent when Low High

a manager uses leverage in an attempt to magnify Leverage
the returns of a weak position or strategy, or [source: NEPC]
grosses up the balance sheet without having a

3 Leverage, Hedge Funds and Risk

A host of fundamental characteristics such as as- indicating the multiple represented by the level of
set type, industry, maturity/duration, credit qual- debt above the equity (Debt/Equity).
ity, and the like are useful in understanding the
extent to which long and short positions will be- Some funds use little or no leverage. For instance,
have similarly or diverge. Leverage as it relates to many distressed credit managers currently have
hedge funds is indeed a bit trickier to conceptual- 30% or more of their portfolio in cash (though the
ize than in the cases of banks or houses since existence of cash on the balance sheet does not
hedge funds can take both long and short posi- necessarily mean that no leverage is employed as
tions. So, in many cases, leverage may not be a margin financing or derivatives can provide lever-
good indication of the riskiness of a portfolio, age without the full use of all available cash). This
unless it is assessed in the context of other port- is because the opportunities in that space are still
folio and strategy characteristics. High leverage developing. Other strategies do use significant
with low basis risk may be less risky than low lev- leverage. Table 3 below provides a sense for lev-
erage with high basis risk. Importantly, strategies erage levels in various hedge fund strategies.
involving less basis risk will tend to call for more Indeed, the level of leverage used by hedge fund
leverage in order to generate returns. managers varies greatly depending on the strat-
C. Measuring Leverage in Hedge Funds egy employed, for example:

There are a number of ways that leverage can be  Merger arbitrage tends to utilize no or little
defined in the context of hedge funds. The first leverage, typically in the range of 1-2x (Long
and most conservative way to measure leverage Market Value/Capital), depending largely on
in hedge funds is to consider the gross value of the spread at which the equities of merger
assets controlled (longs plus shorts), divided by candidates trade in the market.
the total capital (Gross Market Value/Capital).  Fundamental long/short equity also tends to
For example, a fund with $100 million in equity run between 1-2x, with strategies involving
capital with $80 million invested long, and $70 less basis risk tending to utilize higher levels
million invested short for total gross assets of of leverage.
$150 million, would have gross leverage of 1.5x.The  Convertible arbitrage tends to run between 2-
second way to think about leverage, for hedged 6x, utilizing some leverage to magnify the arbi-
or “relative value” strategies in particular (e.g. trage between the convertible bond and eq-
merger arbitrage, convertible arbitrage, capital uity portion of a company’s capital structure.
structure arbitrage), is to look at the value of the
long assets only, divided by the equity capital  Fixed income arbitrage tends to utilize a high
(Long Market Value/Capital). Generally, this is amount of leverage, from 5x to 10x or more
the easiest way to think about leverage and the because the discrepancies being arbitraged
most common way it is expressed. However, one
should always consider
both numbers. The latter Table 3. Typical leverage in hedge fund strategies
method recognizes in- Typical Typical Current
Leverage Guideline (LMV/Capital)
stances where short po- Leverage Maximum Range
sitions serve to decrease Convertible Arbitrage 4x 6x 1-3x
Corporate Credit 1.5x 3x 0.8-2x
risk, that is, they are spe-
Distressed Debt 1x 1.5x 0.3-0.8x
cific hedges for long po- Event-Driven Equity and Merger Arbitrage 1.3x 2x 0.3-1x
sitions or part of a rela- Fixed Income Arbitrage 8x 15x 2.0-10x
tive value position. Global Macro 5x 10x 1-8x
Sometimes, as refer- Long/Short Equity - Fundamental 1.3x 2x 0.3-1x
enced earlier, leverage is Long/Short Equity - Quantitative 2.5x 5x 1.5-5x
Multi-Strategy 3.5x 6x 1-3x
also expressed in terms
of “turns” of leverage,
[source: NEPC, based on data from hedge funds, funds of hedge funds, prime brokers]

4 Leverage, Hedge Funds and Risk

 are very small (LMV/Capital is used since actively reducing leverage before difficult market
there is generally considered to be low basis environments transpired and assets lost value.
risk in this arbitrage). This is a good example Said differently, we have observed that many
of a strategy in which leverage used is not hedge funds have been effective in varying lever-
comparable to other strategies in trying to age levels throughout the market cycle, utilizing
ascertain riskiness, due to the low basis risk more leverage when opportunities were plentiful
and since the underlying securities typically and valuations attractive, and less when opposite
have lower default probabilities and/or are conditions existed. However, the dynamics of the
highly liquid instruments (sovereigns, agen- most recent cycle, to some extent, beg a question
cies, etc). Having said this, certain funds have relating to cause and effect, with the deleveraging
had poor performance as a result of basis risk of hedge funds in many cases likely contributing
volatility. to price declines across various asset types.

Hedge fund leverage levels have varied signifi- Another wrinkle is how the treatment of deriva-
cantly over time. Generally, levels have dropped tive exposure impacts the calculation of hedge
during market turbulence as leverage became fund leverage. While this issue can be complex,
more difficult and costly to obtain. In the current the basic approach generally used is to
environment, larger, well-established hedge funds “notionalize” all derivative exposures; meaning
utilizing a variety of strategies are finding it easier that the dollar value used to express the leverage
to obtain somewhat attractive financing terms. associated with the derivative is based on how
Table 4 below shows aggregate leverage levels much value the derivative controls.
for one of the leading prime brokers on Wall
Street since early 2008. It clearly shows the his-  In a simple case, if one option is purchased
torical trend mentioned above, with prime broker- for a premium (cost) of $5 and the option con-
age financing dropping to a low in the post- trols 100 shares of a stock trading at $50, then
Lehman bankruptcy period of Autumn 2008. the value used to calculate leverage would be
$5000 ($50 x 100), not the premium of $5.
While hedge funds are constrained by the financ- The value used would generally be $5000
ing environment and must react in accordance irrespective of whether the option was, for
with it, many funds have shown a pattern of pro- example, a call (long) or a put (short), and that

Table 4. Prime broker leverage (Gross market value/Capital)*

* This table refers to gross market value divided by capital. It includes margin financing and some types of swap
financing only. It also does not include financing received by hedge funds from other counterparties.
[source: a large prime broker]

5 Leverage, Hedge Funds and Risk

 these options have very different return pro- common source of hedge fund financing is
files, though in reality they would trade at borrowing from a prime broker who provides
slightly different prices. a form of margin financing, generally at either
the position or portfolio level. Prime broker-
 Another example is a currency forward con- age financing is generally easy to obtain but
tract in which cash flows are exchanged financing terms can be changed on short no-
based on movements in that currency multi- tice. Prime brokerage financing is also typi-
plied by a theoretical, pre-determined no- cally of short duration, resulting in a potential
tional dollar amount. In this case the notional mismatch between the duration of the firm’s
value is generally used in the leverage calcula- assets (take longer to liquidate) and liabilities
tion. (can be called quickly). In order to mitigate
 Using the notional value of the derivative can this risk, hedge funds often seek to add “term
be misleading and may not fully capture the structure” to their prime brokerage margin
risk of the derivative, particularly when selling facilities. If a fund has, for example, a 90 day
an option (as opposed to buying one), be- notice built into their agreement with a prime
cause the worst case loss on such a trade can broker, this keeps the prime broker from cut-
be large and the payoff profile asymmetric. ting financing on a position or terminating a
For example, if one sells credit default swap relationship with a fund altogether on short
protection (analogous to selling insurance on notice and most likely at the worst possible
the default risk of a corporate entity) and col- time. This is a significant concern for hedge
lects a premium, and the company defaults, funds using leverage. In the current environ-
the seller has a loss equal to the value of the ment, not all hedge funds have been able to
security ensured minus the premiums col- add term financing to their balance sheet, and
lected. Alternatively, if one buys an option the prime brokers are being very selective about
downside is generally capped at the premium extending credit. Better treatment accrues to
paid. In other cases the loss is theoretically larger, more established funds with steady
unlimited (e.g. short a call). returns, diverse assets and strategies, and
locked-up equity capital.
 There are other techniques that can, in some
cases, be overlaid on this calculation to try to When a security is borrowed from a broker
account for these limitations, including ac- and sold short, a hedge fund receives cash
counting for the “delta” or sensitivity of an proceeds from the sale, on which it is paid
option to changes in the value of the underly- interest at prevailing rates (there is also a cost
ing security (this applies to options in particu- associated with borrowing the security that is
lar due to their convex payoff profiles). a function of how difficult the security is to
obtain, known as the cost of borrow, with the
D. How Hedge Funds Obtain Leverage difference between the two known as the
short sale rebate). Certain prime brokerage
Our hedge fund manager due diligence not only arrangements allow the borrower to reinvest
looks at the level of leverage used, but also, im- these proceeds to purchase additional securi-
portantly, its source and nature. These details are ties long. Prime brokerage is limited in terms
critical, since the sudden withdrawal of financing of the level of leverage it can provide (though
can force liquidation of positions, generally at the certain forms of prime brokerage financing
least opportune time. It is also important to un- allow leverage to exceed Reg T limits), thus
derstand how much total leverage is at the dis- banks and hedge funds have over the years
posal of the manager, to get a handle on how developed creative structures to provide
much “gas” the manager can apply to the portfo- greater levels of borrowing.
lio. Let’s look at some of the methods and instru-
ments hedge funds use to obtain leverage.  Repurchase agreements (aka “repo”): An-
other source of hedge fund financing, particu-
 Prime brokerage: The simplest and most larly for those trading fixed income instru-

6 Leverage, Hedge Funds and Risk

 ments, is repurchase agreements, or repos. In fear of being forced to sell at the wrong time,
a repo transaction, a hedge fund typically de- though banks have in a few cases found ways
livers a security that it owns to a lender as to back out of these financing lines.
collateral in exchange for a loan. Repo trans-
actions are generally of a fixed, short term  Structured financing vehicles: The most so-
nature ranging from one night to one month. phisticated hedge fund managers were able
With the perception of counterparty risk cur- to structure transactions to provide longer
rently at relative high levels, though, most term financing for their portfolios. These vehi-
repo transactions are of the overnight variety, cles, structurally similar to CLOs or CDOs,
limiting their value in the current environ- were a creation of the leveraged economy,
ment. and are difficult to issue in the current envi-
ronment, since few investors are willing to
purchase their debt. Those funds that created
these structures and purchased portfolio as-
IT IS ALSO IMPORTANT TO UNDERSTAND sets with the proceeds have a long term, sta-
ble, cheap form of financing for their portfo-
HOW MUCH TOTAL LEVERAGE IS AT THE lios.
DISPOSAL OF THE MANAGER, TO GET A
 Derivatives: Derivatives of all kinds, including
HANDLE ON HOW MUCH “GAS” THE
options, futures, and forward contracts, con-
MANAGER CAN APPLY TO THE tain implicit leverage. As discussed above,
PORTFOLIO. utilizing a relatively small amount of margin,
these contracts allow the investor to “control”
a much larger level of notional assets. This is
 Total return swaps (“TRS”): Hedge funds slightly different in the sense that derivatives
can also obtain financing through TRS facili- allow for leverage without the fund having to
ties with banks. A TRS allows a hedge fund to actually borrow money to finance their posi-
receive the leveraged ‘total return’ of an un- tions (off balance sheet).
derlying asset or pool of assets. Bank loans
and equities have historically been the most E. Hedge Funds and Leverage...What Can Go
common security financed through TRS. TRS Wrong?
transactions are typically structured in such a We have addressed how hedge funds apply lever-
way that is tailored to the specifics of the un- age, how investors can measure it, and how lever-
derlying asset pool. TRS facilities in place age is obtained. Let us now tie this all together in
around banks loans and other types of collat- an attempt to understand the practical risks of
eral can be an attractive source of term fi- leverage in hedge funds. It is critical to recognize
nancing, though many of these have safe- in what circumstances leverage can be an appro-
guards in place that allow the bank to take priate tool used to generate attractive returns
away the financing if, for example, the market and, on the flipside, how leverage can interact
value of the collateral were to deteriorate. with and feed on other risks, becoming quite dan-
 Secured credit line: A secured line of credit, gerous. To do so, we will look at some real world
though difficult to obtain at fair financing examples.
rates in the current environment, is another To understand what can go wrong, we must first
source of financing for hedge funds. This is look at a typical leveraged hedge fund balance
typically structured as a committed revolving sheet (see next page).
line of credit that is renewable on a periodic
basis supported by certain assets held in the On the right hand side of the balance sheet we
fund. A hedge fund who has obtained this have the liabilities, known as the “capital struc-
source of financing has an advantage in the ture” of the fund. In light blue, we have the inves-
marketplace today as it allows them to pur- tor capital, or equity. At the top, in darker blue,
chase assets with a longer duration with little

7 Leverage, Hedge Funds and Risk

are the financing sources, or debt. This financing the collateral or “haircut” required by a lender in
could take the form of prime brokerage margin, a order to extend credit. It provides a buffer for
secured credit line or other credit facility, as dis- volatility in the assets being leveraged. If the
cussed earlier. In addition, the right side of the volatility or the probability of loss in these assets
balance sheet includes shorted securities, since is high, larger margin levels will be required. For
these are borrowed and then sold, representing a example, a portfolio of government bonds will
liability. In many cases, the cash obtained from require much less margin than one of high yield
the sale can then be used to purchase additional bonds. Hedge funds are currently making every
securities long. Derivatives, in orange, can be ei- attempt to maintain the least amount of margin
ther an asset or a liability, depending on whether with their lenders in order to minimize counter-
the fund is long or short the derivative. In a case party risk. This brings us to the last piece of the
in which the fund is selling credit default swap asset side of the balance sheet, which is cash.
protection, for example, this would be a contin- Depending on the strategy, most funds will be
gent liability of the fund (though in this example able to hold some level of cash on their balance
the liability moves to zero if default does not oc- sheet. Hedge funds have also been careful as of
cur). In some cases, the notional value of deriva- late in terms of where and with whom cash is
tives can be of significant size relative to the over- held, again in order to minimize counterparty risk.
all size of the fund balance sheet.
An asset-liability mismatch is one of the most seri-
Table 5. The hedge fund balance sheet ous problems that can occur with a hedge fund,
most notably in the context of liquidity and/or
Assets Liabilities duration. Most often this mismatch is coupled
Free Cash with an increase in volatility and correlation in the
Financing Sources market. 2008 was a year that saw many examples
Margin (Debt) of this phenomenon.

Let’s look at two funds, Fund A and Fund B. Here

are the basic attributes of each fund:
Securities Investor Capital
(Equity) Fund A

 Invests in diversified long and short portfolio

Derivatives (Off balance sheet exposures)
of 60-80 large cap equities, roughly balanced
but with a modest long bias
[source: NEPC]  Portfolio is financed through prime broker
margin
On the left side of the balance sheet, the asset  Has $100m in equity capital from 10 pension
side, the largest blue box is represented by the funds with long investment time horizons
securities held by the fund. Note that this box is
larger than the light blue box on the right side  Redemption terms are quarterly with 90 days
representing investor capital; this indicates that required notice before the redemption date
the fund is using leverage, otherwise it would only
be able to purchase securities up to the value of  Leverage is low at 1.3x (LMV/Capital), the
the equity provided by its investors. As men- fund has gross long assets of $130m
tioned, derivatives can represent either an asset  The fund is 130% long and 100% short
or a liability on a fund’s balance sheet. In a case in
which the fund is buying protection on CDS, this  10% of the fund’s NAV is in cash
would be considered an asset of the fund (though
the asset value moves to zero if default does not Fund B
occur). We also have cash and margin. Margin is  Invests in a concentrated credit strategy with

8 Leverage, Hedge Funds and Risk

 20 long stressed and distressed bond posi- This is a problem in that the long and short books
tions and 10 short positions, including some may behave very differently. Conceivably, over
equity index shorts and some corporate any particular period, the fund could, for example,
credit index (CDX) buy protection lose money on its longs and also lose money on its
shorts. Thirdly, the fund’s 3x leverage is obtained
 Cash positions are financed with prime bro- through prime broker margin and repo without
ker margin and derivatives are used built-in term structure Given the nature of the
 Has $100m in equity capital from two funds of assets, less liquid distressed securities, it is ques-
hedge funds tionable as to whether a prime broker would in
the current environment provide financing up to
 The two fund of funds who invest in Fund B 3x, but let’s say this is possible for the sake of ar-
obtained their capital from several Swiss den- gument.
tists
Here is how things might unfold:
 Redemption terms are monthly with 30 days
required notice before the redemption date Fund A

 Leverage is moderate at 3x (LMV/Capital),  The perfect storm hits but the fund remains
the fund has gross long assets of $300m flexible; it can reduce, add, or eliminate posi-
tions. The fund suffers idiosyncratic events in
 The fund is 300% long and 250% short 3 positions that are down between 30% and
50%. The fund eliminates two of these and
 10% of the fund’s NAV is in cash adds to one. The vast majority of the fund’s
Now let’s put each fund through a perfect storm, long and short positions are financed with
much like the one witnessed in the fall of 2008, cash. Most of the positions financed with mar-
with the following basic parameters: gin turn out to be some of the less volatile
positions in the portfolio; the fund receives
 Equity and bond markets sell off materially margin calls on a few of these positions but
easily meets these with cash from other posi-
 Market volatility spikes tions it sold.
 Correlation amongst similar securities spikes  The investors of the fund are concerned, but
 Typically less liquid securities become impos- the manager is able to explain that it sees the
sibly illiquid, with no bids current market conditions as a temporary ab-
erration, that the fund remains very nimble,
 Idiosyncratic risk increases and that most of the losses are mark to mar-
ket only and not realized. Most investors
 Default probability increases seem to be on board, with only 8% of fund
 Investors, particularly Swiss dentists, become capital requesting withdrawal for next quar-
very skittish and move to cash (cash is king!) ter.

Which fund is most likely to be able to survive this  The fund is hurt on the long portfolio but the
type of market? Fund A is diversified, trades liq- short portfolio moves up, as expected. The
uid securities, uses little leverage, and appears to fund loses 4% over the course of a month,
have a stable capital base. Fund B is quite differ- down -12% on its longs and gaining +8% on its
ent. First, the latter fund is concentrated with shorts.
only 20 longs and 10 shorts. With $300 million  Though the fund performed poorly during the
invested across only 20 long positions, the aver- storm, it will live to fight another day, and may
age position size is $15 million, or 15% of NAV even be in a position to pick up some bargains
(equity capital). Secondly, the fund has significant in the beaten up market. Its financing provid-
basis risk between its long and short positions. ers are comfortable with the current portfolio

9 Leverage, Hedge Funds and Risk

 and continue to extend credit to the fund. from financing providers and investors look-
Investors are not happy about losing money, ing to redeem, the fund has no flexibility to
but still believe in the fund. hold its slumping positions, much less buy into
opportunities. The prime broker is loathe to
Fund B continue to finance the fund and, although
 The fund is in a dire situation. It suffers idio- leverage is now down to 1.5x (LMV/Capital),
syncratic events in 6 positions that are down this number may be forced down further, es-
between 30% and 60%. The fund receives pecially if markets don’t turn around. The
margin calls on these and other positions. It prime broker is also watching to see how the
uses cash on hand to meet a few margin calls redemption situation of the fund evolves, and
and attempts to sell some of its more liquid most likely will shortly pull all of the fund’s
positions to meet the others, but in the mar- financing.
ket’s flight to quality there is a lack of bids for Table 6. Factors that determine appropriate hedge
their positions and prices gap down. The fund leverage levels
fund lacks flexibility and is forced to sell posi- Leverage Level
tions at fire sale prices, even though it be- High Moderate Low
lieves these will ultimately recover, in order High
Asset credit
to meet margin calls. Some securities are im- Moderate
quality/price
possible to sell as there are absolutely no Low
bids. High
Asset duration Moderate
 To make matters worse, the fund’s investors Low
have learned of the fund’s woes and have
asked the manager to return 50% of the High
Asset liquidity Moderate
fund’s capital before the 30 day redemption
Low
deadline expires. These funds of funds have
their own pressures, as the Swiss dentists High
Asset price
have lost confidence in them and are asking Moderate
correlations
for their capital back. In a panic to raise addi- Low
tional capital, the manager continues to sell High
Asset price
positions, realizing significant additional Moderate
discovery
losses. Low

 The storm causes many of the fund’s longs to High

Asset volatility Moderate
gyrate wildly, losing a great deal of value,
Low
while other positions show little price discov-
ery and liquidity and prices appear to fluctu- High
Portfolio basis
ate less. Generally, the fund’s positions are Moderate
risk
much more volatile than the manager antici- Low
pated. In the end, the short book does fairly High
Position
well, but unfortunately gains much less than Moderate
concentration
what is lost on the long side. Within 4 weeks, Low
the fund has lost 18% of its value, losing 25% High
on the long side and gaining only 7% on the Stability of
Moderate
capital base
short side. Low

 The fund’s future is uncertain and it may be High

Term of
doomed. The fund has lost 18% of its value financing base Moderate
Low
because it applied significant leverage to a
{source: NEPC]
risky, illiquid space and its portfolio had mate-
Green = Acceptable
rial imbedded basis risk. Due to pressure Yellow = Use caution
Red = Dangerous

10 Leverage, Hedge Funds and Risk

 The table on the previous page summarizes a list dress these complex topics directly with manag-
of key factors that dictate the appropriateness of ers. Hedge fund managers, for their part, are re-
the leverage level used, coupled with examples alizing that it is also in their best interest to be
where various factors are combined to create sure that investors fully understand these risks,
differing scenarios. Many hedge funds have lost and that both sides should not focus solely on the
material amounts or even all of their value by ap- reward side of the equation.
plying leverage to particular assets or a portfolio
of assets in an inappropriate manner, such as in
the “dangerous” scenario above (for instance, in
the case of hedge funds run by Bear Stearns).
Excessive growth of the capital base is also dan-
gerous as it creates a situation where the man-
ager must deploy assets, potentially growing the
balance sheet using lower conviction ideas. In
each case, the combination of factors causing the
crisis has been unique. Finally, and perhaps most
importantly, manager hubris has almost always
been a factor in the demise of hedge funds.
There is no doubt that the human element is a
critical piece of analyzing hedge fund risk, making
qualitative analysis, such as understanding the
incentives of the investment professionals run-
ning a hedge fund, as important as understanding
the quantitative aspects.

F. Conclusion

Hedge funds will continue to use leverage to en-

hance their alpha generation capabilities, and
while we do not believe that leverage is a require-
ment, we do think that those funds that can ob-
tain and use it appropriately may have a competi-
tive advantage going forward. Indeed, recent
market turbulence highlights the importance of
focusing on high quality hedge fund firms that
have developed well-structured, robust invest-
ment processes to address both investment risk
and operational risks that can easily translate into
investment risk, all while achieving their invest-
ment objective through a variety of market envi-
ronments.

For many of these managers, leverage will remain

an important tool for achieving their return goals.
Now more than ever, investors must take a pru-
dent and thoughtful approach to assessing not
just leverage, but a variety of risks imbedded in
hedge funds, and they must be prepared to ad-

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