Hedge Fund Leverage and the EU Directive

November 18th, 2009
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Contributed by: Claude Bovet, SFCS Capital
The currently proposed EU Alternative Investment Funds Managers (AIFM) Directive that is slated to come into law next year has raised a lot of concern in the hedge fund industry. The Association for Alternative Investment Management (AIMA), the global hedge fund association, has launched a fervent campaign to address some of the perceived problems with this controversial directive.

The use of leverage, subsequent to the events of 2008, has become understandably contentious. Hedge funds, banks and other financial institutions employ leverage. Bank leverage in particular has raised significant concern as it’s been revealed that the large investment banks were leveraged, in many cases, 40 times and even 50 times their equity capital prior to the financial market collapse in 2008. Some have pointed a finger at hedge funds accusing them of running such inordinately high levels of leverage. This has not been the case. HFR estimates that hedge fund leverage (defined as assets over equity) across all investment strategies has been averaging a moderate 2.5 times equity since 1990. The ECB estimates for leverage in 2009 suggest that hedge funds had reduced leverage such that they were on average less than fully invested (i.e. no leverage at all) with many funds holding significant cash levels.

The European Union’s desire to limit the use of leverage by hedge funds raises an interesting question: should hedge fund leverage be regulated and, if so, how? AIMA is against direct regulation by regulatory authorities of the leverage an individual fund can use. Rather, AIMA suggests that the prime broker be responsible for providing lending data to the regulatory authorities. This reporting by the prime broker is certainly reasonable and should, at the minimum, be implemented but, in my opinion, this is only a partial solution. Let’s review some of the sticky issues with leverage.

Human beings are not rational investors. 2008 should have (finally) laid this fallacy to rest. Irrational behavior will lead to bubbles and a crisis once they pop. Bubbles come in all shapes and sizes; they are not limited to the global variety. The bursting of a bubble will inevitably reveal a substantial amount of leverage in the system in the form of out-right borrowings (quantity) and lower credit standards (prevalence). When the crisis hits, asset values inevitably decline thus lowering the supporting equity of a loan. This puts immediate pressure on the borrower to raise cash to support the declining equity value, and the cycle begins as margin calls beget forced sales beget lower asset values, and so on.

In the 1920’s in the US it was possible to buy stocks on initial margin of 10% (and lower in the bucket shops). 10% margin equates to 9 times leverage on listed stocks. Well, times have changed and initial margin has been at 50% since the Crash. This equates to 2 times leverage, just below the average leverage of the hedge fund industry, when measured on a loan-to-equity basis (i.e. not including off-balance sheet derivatives which could have a net increasing/decreasing effect).

Rules are important. Without them we would not have a fair and secure playing field. However, they should not be overly constraining such that we inhibit innovative spirits. Hedge funds use leverage just as an investor would buying stocks on margin, a widespread and active strategy; that is, to increase potential returns. Hedge funds, however, typically net out market risk by going long and short similar securities. For instance, a hedge fund could purchase Google and sell short Microsoft (owner of Yahoo!). The combination of the long exposure to Google with the short exposure to Microsoft means that market risk (i.e. the risk associated with the current underlying bullish or bearish tendency of the broad stock market) has been hedged out and what remains is generally stock-specific risk. This exposure is far less risky than just being long stocks (or short stocks, for that matter) suggesting that hedge funds can bear a higher level of commensurate risk to its long-only brethren. This is, of course, an oversimplification but a useful example nonetheless.

The problem with leverage, however, is that it is not very cooperative at that precise moment when we most need it to be! Take 2008 as an example. Markets were crashing, asset prices were falling through the floor, uncertainty prevailed, panic ensued. Your credit provider places a call for more liquid capital (read: cash) to bolster your disappearing equity. You either provide the additional capital, or your loan is called in. You are effectively cornered: put up or pull out. Unable to get your hands on more cash, you are forced to sell at a loss. If you had not borrowed to leverage up, you would (theoretically, because there are other considerations) be able to sit out the decline. Warren Buffet seems to have done precisely this with his pile of cash, $44 billion to be precise. Berkshire Hathaway did, however, decline by 50% peak-to-trough, but he is still around to fight another day. It is, of course, far better to not register a losing year at all.

Leverage is a double-edged sword; it allows you to increase your returns, but it can shed your own blood if you are not careful. Too much leverage is simply an accident waiting to happen. This leads me to my conclusion: the amount of leverage that a hedge fund can employ, in my opinion, should be limited. How it is limited is a harder question to answer. AIMA suggests utilizing a template approach with the prime brokers to ensure leverage does not get out of control. This seems like a partial answer. If pushed, they also propose employing a similar mechanism to the Basle II Accord required for banks that would need to be adapted to the hedge fund industry. This makes more sense to me. Such a mechanism would weight the risk profile of an asset (Level 1, 2, and 3 bank equivalents) such that a US Treasury bill would carry with it a higher potential loan level than a position in the stock of GE, for instance. This is an adaptive approach that more directly addresses the risk of too much leverage yet provides the hedge fund manager with the flexibility to adjust his leverage depending on the quality of his collateral. This is in stark contrast to what the EU is proposing with its AIFM Directive which would impose a fixed maximum leverage level to the entire hedge fund industry. Such an approach inhibits the flexibility of the hedge fund manager and can reduce performance available to the investor.
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