Hedge funds not ‘shrinking violets’

Mae West, noted paragon of virtue that she was, once said “I generally avoid temptation unless I can’t resist it.” The same may be said of hedge funds, not generally considered the shrinking violets of the investments community, in the context of their relationship with Leverage.

Hedge funds live in symbiosis with prime brokers. Neither can exist without the other (almost). Both industries are highly competitive; in their efforts to lure new clients, prime brokers would have dangled credit as a carrot before hedge funds often all-too-easily tempted to use leverage to stay ahead in a returns-driven game. But now, with banks struggling to fund themselves, credit lines to hedge funds have been retracted in dramatic fashion.

If a hedge fund is operating at the maximum levels of leverage permitted by its prime broker, then an increase in the margin requirement means assets must be sold to generate sufficient cash. Since the middle of 2007, the price of credit has been rising, so leverage has become a more costly proposition. But during the first quarter of this year, as risk perceptions increased dramatically, prime brokers began to curtail the amount of credit they were willing to offer to risky funds at any price.

In March 2008 this reached panic proportions, setting in motion a vicious cycle: the assets utilised in a hedge fund’s strategy had become more volatile (mostly on the downside), creating the initial perception of increased risk. Credit lines are reduced, forcing the hedge fund to generate cash by selling assets into the already-weak market, driving their prices lower. At some point, the fund’s investors begin to redeem, which creates even more pressure to sell underlying assets, and so on. Several of the high-profile hedge fund failures unfolded in precisely this fashion, and were a direct result of excessive leverage at the outset. Leverage introduces negative asymmetry. In other words, a three-times leveraged fund is likely to lose more than three times the amount it would have lost had it been un-levered, because of the requirement to sell a larger quantity of assets very quickly.

When considering an investment in a hedge fund, it is utterly essential to consider the amount of gearing used in the strategy and the controls around its use. It’s also imperative to explore the fund manager’s attitude to risk and leverage. Despite the spectacular hedge fund disasters witnessed in recent weeks, leverage is not unequivocally bad. Excessive and poorly understood leverage certainly makes us (as investors in hedge funds) nervous, but a large number of hedge funds do use leverage in a responsible manner. When markets are more volatile, the appropriate response is to reduce leverage, to keep risk levels constant. Prudent fund managers recognize this, but others keep leverage the same making their funds riskier propositions.

Leverage risk is not always fully appreciated by investors. Explicit leverage (borrowing to invest, or operating on margin) is easily monitored. But a full understanding of the fund’s underlying positions is also necessary to clarify the extent of embedded leverage. Many (indeed most) of the tranched structured finance trades available these days provide highly leveraged exposure to changes in credit pricing: even small changes in credit pricing or default assumptions can have a massive impact on the price of the note or swap or tranche in question. These structures can be complex and difficult to analyse, but it is absolutely imperative to do so.

We view the use of leverage by hedge funds as a valid, value-adding tool, but only in skilled hands - fund managers who can resist the temptation of excess leverage when necessary, but who can also harness it correctly when appropriate.

By Sheldon Macdonald, Senior Investment Analyst, Nedgroup Investment Advisors (UK) Limited