Educational Series Vol. 1 - Leverage
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Leverage

By Associate Professor Mick Swartz, Ph.D. (Finance), CAIA in the Finance and Business Economics Department at the University of Southern California. Professor Swartz is on the Board of CalALTs.

January 2013

 

The concept of leverage and how it is used by asset managers is one of the more misunderstood topics in the hedge fund industry. Broad generalizations about leverage are rarely on point as the amount and type of leverage used by managers will vary greatly from strategy to strategy and will often depend on the specific instruments being traded by a particular manager. The term leverage is also not necessarily a synonym for risk, as many commentators on the hedge fund industry would lead the investment world to believe. The amount of risk and reward added by a manager’s use of leverage will vary greatly, again depending upon the trading strategy being employed and the types of instruments being traded. With this first volume in the CHFA Educational Series, I attempt to shed some light on the matter of leverage and the evolution of its use in the hedge fund industry over the past several years.

 

Many hedge fund managers and their investors have felt the impact of the evolving availability of leverage over the last 8 years. In 2005, leverage in the form of debt was widely available to allow many inherently basic hedge fund strategies to thrive. Strategies with only moderate profit opportunities were essentially able to leverage positions (using large levels of debt) into outsized returns and create an industry boom. With the financial crisis in 2008 and the subsequent deleveraging of the entire global economy however, the availability of leverage decreased substantially for many types of funds. And while some hedge fund areas are just beginning to return to similar levels of leverage, many funds are still unable (or unwilling) to obtain the same levels of credit that they were able to obtain pre-2008 and their performance has suffered as a result.

 

It seems counterintuitive that in the current “zero interest rate” world that leverage is not as readily available as it was prior to 2008. However, given the depth of the crisis financial institutions faced, institutions remain wary of providing large amounts of leverage for hedge fund strategies. Still baring the scars of 2008, investors and financial institutions place a higher premium on liquidity today than ever before. As a result of this trend, leverage is generally less available to hedge fund managers today. Even if the leverage is available there terms are usually shorter and more onerous than several years ago. This poses a problem for the industry because the ability of many strategies to survive depends on the availability of leverage in the marketplace. A sustainable strategy that can withstand many market environments depends on regular cash flows to sustain expenditures and market downturns. As the old saying goes, “cash is king” during a crisis and for the hedge fund industry, the crisis continues. Until credit conditions improve, the lack of readily availability leverage will continue to be a problem for many managers.

 

Notwithstanding the decreased availability of leverage, many investors fail to realize hedge fund strategies can and have remained quite profitable over the last several years and have continued to show the ability to serve as great portfolio diversifiers. In addition, the lack of availability of leverage has hastened the convergence of the hedge fund industry and the traditional asset management industry, thereby creating some exciting new investment opportunities for investors. Specifically, many traditionally long-only managers have launched mutual funds and ETFs that mimic some of the diversifying characteristics of hedge fund strategies. While the jury remains out on many of these new “liquid alternative” products in terms of delivering meaningful returns, some show a great deal of promise as means to bring the diversifying power of alternative investment strategies to a broader audience of investors.

 

Going forward, it is critical that investors understand any strategy they are considering for investment and in particular how much, if it all, the potential success of the strategy dependent on a manager’s use of leverage. Is a particular hedge fund manager bringing a particular and unique skills to bear in the markets or rather, is the manager simply using leverage to “goose” what is an inherently basic investment approach that could be replicated more cheaply elsewhere? Is a manager’s use of leverage truly enhancing the risk/reward ratio of the investment strategy or is it simply adding undue risk without providing a commensurate opportunity for upside? The answer to these and other related questions will go a long way toward dictating how an investor’s capital is best allocated going forward and allow investors to better navigate the often-misunderstood concept of leverage.

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