One popular misconception about hedge funds is that they employ excessive amounts of borrowed or notional capital to bolster returns, making them extremely risky to investors. Some industry experts, however, believe the contrary may be true.
Leverage, in the context of hedge funds, is the use of financial instruments such as derivatives or debt to increase investment exposure. For example, an investor with $100 may be able to purchase 50 shares in a company, but by purchasing 25 option contracts they might be able to control 1,000 shares instead.
This has the potential for greater returns, but also for higher losses, making leveraged investment products more risky. Small changes in the underlying stock are amplified in the leveraged instrument, so volatility is greater.
Investments can also be leveraged by borrowing money or generating extra capital through short selling, borrowing a financial instrument and then selling it in the hope of buying it back at a later date.
Trading on Margin
The most efficient way of leveraging a hedge fund, however, is through trading on margin. Most trades in derivative markets require only a small portion of the available investment capital, as little as 1 percent in currency markets, which means that a $100 investment can theoretically be used to generate $10,000 worth of exposure.
Only a few hedge fund styles, such as managed futures, use these kinds of instruments and can gain this level of exposure. The vast majority of styles are restricted in the leverage they can generate, most notably long/short equity which can generate additional capital through short-selling but has limited options for leveraging long equity holdings.
Sharp Lesson
Long-Term Capital Management was leveraged almost 30 times when, in 1998, Russia devalued its currency and declared a moratorium on $13.5 billion of government bonds. The reversal nearly wiped the company out and raised severe concerns over the use of notional money to bolster returns.
Hedge funds responded by significantly reducing leverage and introducing a host of risk management measures to strengthen their portfolio. In its March 2005 quarterly review, entitled “Time-varying exposures and leverage in hedge funds”, the Bank for International Settlements presented data showing that leverage across the hedge fund industry had fallen from about nine times’ assets to between two and three times’ assets.
Managers also play closer attention to the total value of their assets at risk in every transaction and emphasize greater diversification in their investments to limit exposure to market event risk.
In May this year, US Federal Reserve Vice-Chairman Roger Ferguson noted that the market discipline of hedge funds had improved and observed, “I think hedge funds are not, at this stage, a source of instability, nor likely to become one.”
Too Safe?
That has some industry insiders complaining that hedge funds have become too safe, and calling for the use of additional leverage to boost returns.
They argue that investing is about taking rational risks to generate superior returns and that the current low interest rate environment makes it safe and practical for hedge funds to use leverage and focus on other risk control measures to limit negative volatility.
Whatever the case may be the conception that hedge funds are over-leveraged or too risky is well shy of the market: historically, the asset class is only slight more volatile than bonds and considerably less so than equities. And that includes the period of history where companies like LTCM were leveraged to the hilt.
(Antoine Massad is head of Middle East and Asia at Man Investments in Dubai.)