Hedge funds: Not the juiced-up, ready-to-destroy-financial-markets types many believe

It’s all the rage to talk about the new age of prudence – scaling back from the overextended, over-leveraged days or yore to become properly aligned with the new era of fiscal rectitude.

Hedge funds have of course been no exception to the banter, particularly as most market observers and commentators have already concluded in a guilty-before-proven-innocent way that over-leveraged hedge funds were behind most of the world’s current economic and financial market ills.

Even today, talk persists of hedge funds being dangerous over-leveraged, with the potential for dangerous and dramatic ramifications for global financial markets. Just ask Angela Merkel.

But embedded in a recent report by Boston-based consulting firm Celent entitled, “Hedge Funds in Europe: Riders of the Storm” (the full report is by subscription only, but the press release can be viewed here) is some empiral evidence that strongly suggests hedge funds aren’t nearly as levered up – and in turn as big a risk to the stability of global financial markets – as public opinion might suggest.

The report, which generally focuses on expected dwindling assets under management among European hedge funds and other issues, including the expected impact of the Alternative Investment Fund Management Directive, carries a small section that takes a closer look at leverage utilized among hedge funds by examining a hedge fund’s gross “footprint” across asset classes compared with the equity it has raised from investors. A fund’s gross footprint is the total value of all long and short securities positions held, regardless of how they are held (physically or through derivatives) and ignoring the fact that many of the risks may be offsetting.

What the report concludes is that as of October 31, 2009, the two strategies with the highest ratio of gross footprint to net equity – fixed income and long/short credit, together accounted for less than 10% of surveyed assets under management – far lower than evidence and conjecture combined might suggest.

Indeed, the chart above from a study conducted by the UK Financial Services Authority shows that on October 31, 2009 the aggregate footprint wasn’t greater than 3% of any total market size – hardly what one might deem a giant, leverage-bloated market presence.

What’s more, in European equities, the FSA’s sample had gross positions equal to 0.9% of the value of European equity markets – again, a really small number. Similarly, the gross footprint in many derivatives products was also small in comparison with the Bank of International Settlements’ estimates of market size, according to the report.

The only exception was convertible bonds, where hedge funds seem to comprise a more significant proportion of ownership – 10% of the size of the global convertible bond market.

The report provided further evidence that hedge funds aren’t levered-up, systemic risk-taking animals by looking at borrowing as a multiple of net equity, firstly through prime brokerage and repo, and secondly with synthetic lending also included.

The results: that average cash borrowing for surveyed hedge funds is 202% of net equity, or as they say in the business, about 2 to 1. Fixed income arbitrage funds were the biggest borrowers (through repo) while equity long short funds were among the least to borrow (137% when synthetic borrowing is also included).

What the report’s findings suggest is that the scenario of hedge funds levering up and destroying the financial world is not entirely accurate. In addition to having a smaller collective footprint, borrowing levels are well under control and liquidity of assets is actually sufficient to cover liabilities as and when they arise.

We have to wonder why this bit of good news was buried in the midst of a broader survey, particularly when the majority of the report’s salient conclusions were far from positive. Nonetheless, in a world where pundits and politicians continue to battle each other over who will tighten the noose around the hedge fund industry first, some evidence that leverage – and in turn risk – may not be as prominent as many expect is a bit of good news we’ll take.

We only hope that Chancellor Merkel happens upon Celent’s – and in turn our – findings.

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