The classic hedge fund model is often said to resemble “picking up nickels in front of a steamroller.” To make the nickels add up to anything, you need to jump in front of that steam roller on a regular basis and pick up as many nickels as you can each time. In short, you need to leverage your time.
So it’s no surprise that “excessive leverage” is often invoked by hedge fund critics. Government mandated secrecy allowed rumours of excessive leverage to dog the industry over the past decade, and today many still accuse the industry of endangering financial markets through the cavalier use of borrowed money.
The most popular post on this website in 2009 sought to dispel that myth by aggregating a series of charts from different sources showing that leverage was not nearly the made-for-media story is was made out to be. Average bank leverage, it turned out was at least 10 times that of the average hedge fund.
To be sure, hedge funds use more leverage than mutual funds. And that helped fuel the rumours. And hedge funds’ investment flexibility allowed them to buy securities with embedded leverage (e.g. futures and options). In this post, we covered a McKinsey study of the effects of such embedded leverage. The firm’s conclusion: at its very peak, hedge fund leverage was a paltry 3.5x (explicit and embedded leverage included).
Many of these studies were based on proxies for leverage (such as volatility), on secondary sources such as prime brokerage data, or on surveys of hedge fund managers themselves. But a new paper by Andrew Ang and Sergiy Gorovyy of Columbia University and Gregory van Inwegen of Ivy Asset Management uses self-reported data collected over the years by “a large fund of funds” referred to only as the “Fund”. (Our minds race trying to figure out who it could possibly be.)
They come to some interesting conclusions. But first, they called around to prime brokerages to piece together the following (very useful) table of embedded leverage.
Given this arsenal of weapons available to the unconstrained hedge fund manager, McKinsey’s 3.5x figure seems to be an impressive display of self-restraint.
The trio examined only the explicit leverage reported by managers. Their data generally matches that contained in our 2009 post on hedge fund leverage. Not surprisingly, relative value and credit (two “nickels in front of a steam roller” strategies) had the highest leverage.
Although this leverage is modest compared to banks, the authors remind us of the risk that a prime broker might reign in their explicit leverage or their support for trades that embed leverage. This “financing risk” was the topic of a paper covered here last year by Suresh Sundaresan (one of the authors’ Columbia colleagues whom they thanked on the cover page of their paper.)
Although the average leverage is relatively low, this recent post illustrates why you need to look beyond averages when it comes to financing risk. The following chart from this paper shows that the top quartile of funds has a significantly higher leverage. (Although we note that could just be all the relative value and credit hedge funds.)
This paper is loaded with other observations about leverage. But perhaps its most notable conclusion is that “hedge fund leverage is counter-cyclical to leverage of financial intermediaries” – a finding the authors call “remarkable.” (see chart from paper below)
They report that the correlation between the leverage levels of hedge funds and banks is -0.884 – and roughly the same between hedge funds and investment banks. (Bank/I-Bank leverage defined as total liabilities over market value).
Why? They suggest, as Sundaresan essentially did in his paper, that banks put the screws to hedge funds when their own leverage ratios went south, forcing hedge funds to get “on the wagon” just as the banks were getting intoxicated on debt (and/or their market values began to plummet).
This is an interesting and easy-to follow paper (“easy to follow” meaning we could actually understand it). And if it’s true, as the authors contend, that it “presents the first formal analysis of hedge fund leverage,” then you’ll probably see it cited extensively in the coming years both by academics and, with any luck, by regulators.