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1Leverage, Hedge Funds, and Risk Summer 200

Leverage, Hedge Funds, and RiskLeverage, Hedge Funds, and Risk Frank Barbarino, CAIAConsultant, Hedge Funds

Executive Summary

The current market environment has led investors to reexamine the components of their invest-ment programs, particularly in light of the impact of the credit crisis and its accompanying elevatedmarket volatility. Hedge funds represent an investment category that has experienced significantchallenges, yet we feel they remain an important component of the investment structure for manylong-term investors 1. A key element when evaluating hedge funds is to assess the use of borrowed

capital, or leverage, as a part of their investment strategies and the contribution of leverage to ex-pected return and risk. This topic is especially important given the investment climate of late, char-acterized by constrained availability of leverage and higher borrowing costs, and the contribution of leverage to certain fund blowups in the recent past.

Key takeaways from this paper include:

Leverage should be an important consideration in the evaluation of hedge fund managers. Whileleverage generally amplifies both return and risk, higher leverage does not always indicate higher risk, as it must be understood in the context of other features of an investment strategy.

We do not believe that it is prudent to use leverage to magnify the returns of a low-return position

or strategy, or to increase the size of the hedge fund balance sheet without having a great deal of conviction in the underlying investment ideas.

There are many ways for funds to obtain leverage, each of which offer unique attributes with re-spect to term, stability, cost, and availability. The amount of leverage used by hedge funds canvary substantially, dictated by the strategy being utilized and several other variables.

Analyzing hedge fund balance sheets can help an investor understand how difficult market cir-cumstances can affect funds differently, with some funds able to weather such environmentswhile others suffer greatly or even go out of business.

While the hedge fund communitys access to and use of leverage is evolving, we believe that itcontinues to represent a valid tool in the hedge fund managers toolbox and that managers withbetter access to it may benefit. Furthermore, while the use of leverage has in many cases aug-mented the ability of certain managers and strategies to generate attractive returns, we do not be-lieve that in most cases access to leverage is a prerequisite to alpha generation within the hedgefund space.

1 For a general assessment of hedge funds in the current environment please see our recent research note: HedgeFunds: Broken or Damaged?

The author would like to thank those individuals at NEPC who provided assistance and encouragement throughout the process of writing this paper aswell as those outside of the firm who provided their insights, with a special thanks to professionals from Robeco Sage.


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A. How Leverage Works

We define financial leverage as the level of gross assets greater than equity capital in-vested. Leverage allows for the magnification of the return, and the risk, of the original equity

investment. Leverage exists throughout theeconomy and financial markets. In the case of a company, issuing additional debt rather thanequity has the effect of amplifying the impact of revenue growth on EPS. Here are a couple in-stances of this.

A bank provides a common example of acompany that issues debt, often representinga multiple of more than ten times tangiblebook equity. Before the current crisis, banksfelt confident doing so because they believed

that their mix of assets had relatively low vola-tility (more on this idea later).

The purchase of a house usually involves lev-erage. An equity investment of, say, $100k(20%) and a loan of $400k (80%) to buy a$500k house, represents a four times (4x)leveraged purchase (Debt/Equity).

Individual investors can also apply the princi-ples of financial leverage to their investmentportfolios. A margin account allows an inves-tor to borrow against the value of the securi-

ties and cash held in the account, effectivelyleveraging the return andrisk of those securities100% or 1x (known as theReg T limit).

Lets look at the math behindhow leverage impacts an in-vestment (see Table 1).

In the case of rising assetprices, one can see that lev-erage has a dramaticallypositive effect on the returnon equity (ROE), amplifyinga return on assets (ROA) of 10% to an ROE of 26%when 2x leverage (Debt/Equity) is used. However,with a -10% ROA, 2x lever-age has a very negative im-

pact, with a -34% result in ROE. These exam-ples illustrate the importance of handling lever-age with care.

B. Leverage in Hedge Funds...The Basics

Hedge funds utilize leverage in a similar fashionto the way a bank, the buyer of a house, or astock investor might. As seen above, leverageclearly decreases an investors margin for error.That is, when a relatively small amount of capi-tal controls a large amount of assets, the lossesthat can be sustained from those assets beforethe managers capital becomes impaired can besmall. Therefore, the greater the leverage, theless asset price volatility the manager will beable to endure. The incentive structure andcompetitive environment of hedge funds some-

times leads managers to shoot for a high returnwhile ignoring the risk associated with achievingthat return. This is a reason that manager se-lection in hedge funds, particularly those whouse material levels of leverage, is so critical.

The past few years are filled with examples of hedge funds using leverage to amplify the returnof securities with relatively low yields, or tradeswith modest expected returns. Indeed, if thereturns that are achievable for a managers styledecrease, some managers may be tempted to

Leverage, Hedge Funds, and Risk Summer 200

Leverage (Debt/Equity) 1.0x 2.0xEquity 1,000,000$ 1,000,000$Debt 1,000,000$ 2,000,000$Assets 2,000,000$ 3,000,000$Return on Assets (ROA) 10% 10%Gross Profit/Loss (P&L) 200,000$ 300,000$Cost of Leverage (at risk-free rate of 2%) (20,000)$ (40,000)$Net Profit/Loss (P&L) 180,000$ 260,000$Return on Equity (ROE) 18% 26%

Leverage (Debt/Equity) 1.0x 2.0xEquity 1,000,000$ 1,000,000$Debt 1,000,000$ 2,000,000$Assets 2,000,000$ 3,000,000$Return on Assets (ROA) -10% -10%Gross Profit/Loss (P&L) (200,000)$ (300,000)$Cost of Leverage (at risk-free rate of 2%) (20,000)$ (40,000)$Net Profit/Loss (P&L) (220,000)$ (340,000)$Return on Equity (ROE) -22% -34%

Asset Prices Rise

Asset Prices Fall

Table 1. The impact of leverage on investment returns

[source: NEPC, adapted from a table used by an investment manager]


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increase leverage to make up the difference.One example of this phenomenon is that of hedge funds investing in bank loans throughout2007 and 2008. Bank loans have historicallybeen relatively stable investments, mainly be-cause they sit toward the top of the corporatecapital structure and are secured by assets of the company. They have historically had lowlevels of default, and, in cases in which defaultsdid occur, high recovery rates. In recent yearsthese loans traded at very narrow yield spreadsas demand from Collateralized Loan Obligations(or CLOs, a leveraged structure that buysbank loans), hedge funds (using leverage facili-ties called total return swaps, or TRS, more onthose later), and other leveraged market partici-pants bid up prices. The tighter spreads be-came, the more leverage was applied in order to

make yields attractive to investors. The rest of the story is history, as they say, with investors inCLOs, hedge funds, and other leveraged vehi-cles losing money in bank loans beginning inthe summer of 2007 as spreads widened withmore and more market participants attemptingto sell.

We view strategies that are dependent on sig-nificant leverage in order to generate adequatereturns as generally less attractive. This ismore true in todays environment, because lev-erage is not as easy to obtain as it was in thepast. Conversely, due to the broad selloff of risky assets, in many cases less leverage is cur-rently needed in order to obtain attractive re-

turns. Certain hedge fund strategies do employmoderate leverage, and many well-implementedstrategies can have good portfolio diversificationeffects and attractive risk/return dynamics.Generally, we are comfortable if a manager isusing leverage in order to amplify the return of acompelling position or strategy or if the manager is seeing many high potential return opportuni-ties.


In contrast, however, we feel it is imprudentwhen a manager uses leverage in an attempt tomagnify the returns of a weak position or strat-egy, or grosses up the balance sheet withouthaving a great deal of conviction in his posi-tions. Investor skill and experience are requiredin order to distinguish between these two sce-narios.

The level of leverage used by a hedge fund can-not be observed in isolation as an indicator of the riskiness of that fund or its underlying strate-gies. Understanding the details of each man-agers trading style, the return drivers of thestrategies implemented, and the construction of the portfolio are essential to the evaluation of amanagers leverage and risk profile. We at-tempt to determine an appropriate leverage

level based on the strategies and sub-strategiesemployed, and based on our experience of whatlevels of leverage a manager should be utilizingin their portfolios given such a strategy.

The riskiness of leverage depends on whatpositions are being leveraged. When assetsthat are expected to move in conjunction in-stead diverge, this is a notion called basis risk.This is the risk that two assets behave differ-ently to one another and lose money at thesame time. For example, if a manager appliesleverage to a position consisting of two verysimilar securities, one long and one short (e.g.Long Nike stock, Short Reebok stock), this ismuch less risky than applying that same level of leverage to a position consisting of two dissimi-lar securities (Long Exxon stock, Short JetBluestock). This is because the price of the similar assets will tend to move in tandem, with thegains on one offsetting the losses on the other.

A host of fundamental characteristics such asasset type, industry, maturity/duration, creditquality, and the like are useful in understanding

the extent to which long and short positions willbehave similarly or diverge. Leverage as it re-lates to hedge funds is indeed a bit trickier toconceptualize than in the cases of banks or houses since hedge funds can take both longand short positions. So, in many cases, lever-age may not be a good indication of the riski-ness of a portfolio, unless it is assessed in thecontext of other portfolio and strategy character-

The past few years are filled with examples of hedge funds using leverage to amplify the return of

securities with relatively low yields, or trades with modest expected returns.


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istics. High leverage with low basis risk may beless risky than low leverage with high basis risk.Importantly, strategies involving less basis riskwill tend to call for more leverage in order togenerate returns.

[source: NEPC]

C. Measuring Leverage in Hedge Funds

There are a number of ways that leverage canbe defined in the context of hedge funds. Thefirst and most conservative way to measure lev-erage in hedge funds is to consider the gross

value of assets controlled (longs plus shorts),divided by the total capital (Gross Market Value/Capital). For example, a fund with $100 millionin equity capital with $80 million invested long,and $70 million invested short for total grossassets of $150 million, would have gross lever-age of 1.5x. The second way to think about lev-erage, for hedged or relative value strategiesin particular (e.g. merger arbitrage, convertible arbi-trage, capital structurearbitrage), is to look at the

value of the long assetsonly, divided by the equitycapital (Long MarketValue/Capital). Generally,this is the easiest way tothink about leverage andthe most common way it isexpressed. However, oneshould always consider both numbers. The latter

method recognizes instances where short posi-tions serve to decrease risk, that is, they arespecific hedges for long positions or part of arelative value position. Sometimes, as refer-enced earlier, leverage is also expressed interms of turns of leverage, indicating the multi-ple represented by the level of debt above theequity (Debt/Equity).

Some funds use little or no leverage. For in-stance, many distressed credit managers cur-rently have 30% or more of their portfolio incash (though the existence of cash on the bal-ance sheet does not necessarily mean that noleverage is employed as margin financing or derivatives can provide leverage without the fulluse of all available cash). This is because theopportunities in that space are still developing.

Other strategies do use significant leverage.Table 3 below provides a sense for leveragelevels in various hedge fund strategies.

Indeed, the level of leverage used by hedgefund managers varies greatly depending on thestrategy employed, for example:

Merger arbitrage tends to utilize no or littleleverage, typically in the range of 1-2x (LongMarket Value/Capital), depending largely onthe spread at which the equities of merger candidates trade in the market.

Fundamental long/short equity also tends torun between 1-2x, with strategies involvingless basis risk tending to utilize higher levelsof leverage.

Convertible arbitrage tends to run between 2-6x, utilizing some leverage to magnify the


Table 3. Typical leverage in hedge fund strategies

Leverage Guideline (LMV/Capital)Typical

LeverageTypical

MaximumCurrentRange

Convertible Arbitrage 4x 6x 1-3xCorporate Credit 1.5x 3x 0.8-2xDistressed Debt 1x 1.5x 0.3-0.8xEvent-Driven Equity and Merger Arbitrage 1.3x 2x 0.3-1xFixed Income Arbitrage 8x 15x 2.0-10xGlobal Macro 5x 10x 1-8xLong/Short Equity - Fundamental 1.3x 2x 0.3-1xLong/Short Equity - Quantitative 2.5x 5x 1.5-5xMulti-Strategy 3.5x 6x 1-3x

[source: NEPC, based on data from hedge funds, funds of hedge funds, prime brokers]

BasisRisk

Leverage

High

Low

Low High

Dangerous

Use caution

Use caution

Acceptable

Table 2. Hedge funds and Basis Risk


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arbitrage between the convertible bond andequity portion of a companys capital struc-ture.

Fixed income arbitrage tends to utilize ahigh amount of leverage, from 5x to 10x or

more because the discrepancies being arbi-traged are very small (LMV/Capital is usedsince there is generally considered to be lowbasis risk in this arbitrage). This is a goodexample of a strategy in which leverageused is not comparable to other strategies intrying to ascertain riskiness, due to the lowbasis risk and since the underlying securi-ties typically have lower default probabilitiesand/or are highly liquid instruments(sovereigns, agencies, etc). Having saidthis, certain funds have had poor perform-

ance as a result of basis risk volatility.

Hedge fund leverage levels have varied signifi-cantly over time. Generally, levels havedropped during market turbulence as leveragebecame more difficult and costly to obtain. Inthe current environment, larger, well-establishedhedge funds utilizing a variety of strategies arefinding it easier to obtain somewhat attractivefinancing terms. Table 4 below shows aggre-gate leverage levels for one of the leading primebrokers on Wall Street since early 2008. It


clearly shows the historical trend mentionedabove, with prime brokerage financing droppingto a low in the post-Lehman bankruptcy periodof Autumn 2008.

While hedge funds are constrained by the fi-

nancing environment and must react in accor-dance with it, many funds have shown a patternof proactively reducing leverage before difficultmarket environments transpired and assets lostvalue. Said differently, we have observed thatmany hedge funds have been effective in vary-ing leverage levels throughout the market cycle,utilizing more leverage when opportunities wereplentiful and valuations attractive, and lesswhen opposite conditions existed. However, thedynamics of the most recent cycle, to some ex-tent, beg a question relating to cause and effect,

with the deleveraging of hedge funds in manycases likely contributing to price declines acrossvarious asset types.

Another wrinkle is how the treatment of deriva-tive exposure impacts the calculation of hedgefund leverage. While this issue can be complex,the basic approach generally used is tonotionalize all derivative exposures; meaningthat the dollar value used to express the lever-age associated with the derivative is based onhow much value the derivative controls.

Table 4. Prime broker leverage (Gross market value/Capital)*

* This table refers to gross market value divided by capital. It includes margin financing and some types of swap financing only. It also does not include financing received by hedge funds from other counterparties.[source: a large prime broker]


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In a simple case, if one option is purchasedfor a premium (cost) of $5 and the optioncontrols 100 shares of a stock trading at$50, then the value used to calculate lever-age would be $5000 ($50 x 100), not thepremium of $5. The value used would gen-erally be $5000 irrespective of whether theoption was, for example, a call (long) or aput (short), and that these options have verydifferent return profiles, though in realitythey would trade at slightly different prices.

Another example is a currency forward con-tract in which cash flows are exchangedbased on movements in that currency multi-plied by a theoretical, pre-determined no-tional dollar amount. In this case the no-tional value is generally used in the leverage

calculation.

Using the notional value of the derivativecan be misleading and may not fully capturethe risk of the derivative, particularly whenselling an option (as opposed to buyingone), because the worst case loss on such atrade can be large and the payoff profileasymmetric. For example, if one sells creditdefault swap protection (analogous to sellinginsurance on the default risk of a corporateentity) and collects a premium, and the com-pany defaults, the seller has a loss equal tothe value of the security ensured minus thepremiums collected. Alternatively, if onebuys an option the downside is generallycapped at the premium paid. In other casesthe loss is theoretically unlimited (e.g. shorta call).

There are other techniques that can, insome cases, be overlaid on this calculationto try to account for these limitations, includ-ing accounting for the delta or sensitivity of an option to changes in the value of the un-

derlying security (this applies to options inparticular due to their convex payoff pro-files).

D. How Hedge Funds Obtain Leverage

Our hedge fund manager due diligence not onlylooks at the level of leverage used, but also, im-portantly, its source and nature. These detailsare critical, since the sudden withdrawal of fi-

nancing can force liquidation of positions, gen-erally at the least opportune time. It is also im-portant to understand how much total leverageis at the disposal of the manager, to get a han-dle on how much gas the manager can applyto the portfolio. Lets look at some of the meth-ods and instruments hedge funds use to obtainleverage.

Prime brokerage: The simplest and mostcommon source of hedge fund financing isborrowing from a prime broker who providesa form of margin financing, generally at ei-ther the position or portfolio level. Prime bro-kerage financing is generally easy to obtainbut financing terms can be changed on shortnotice. Prime brokerage financing is alsotypically of short duration, resulting in a po-

tential mismatch between the duration of thefirms assets (take longer to liquidate) andliabilities (can be called quickly). In order tomitigate this risk, hedge funds often seek toadd term structure to their prime brokeragemargin facilities. If a fund has, for example,a 90 day notice built into their agreementwith a prime broker, this keeps the primebroker from cutting financing on a position or terminating a relationship with a fund alto-gether on short notice and most likely at theworst possible time. This is a significant

concern for hedge funds using leverage. Inthe current environment, not all hedge fundshave been able to add term financing totheir balance sheet, and prime brokers arebeing very selective about extending credit.Better treatment accrues to larger, more es-tablished funds with steady returns, diverseassets and strategies, and locked-up equitycapital.

When a security is borrowed from a broker and sold short, a hedge fund receives cashproceeds from the sale, on which it is paidinterest at prevailing rates (there is also acost associated with borrowing the securitythat is a function of how difficult the securityis to obtain, known as the cost of borrow,with the difference between the two knownas the short sale rebate). Certain prime bro-kerage arrangements allow the borrower toreinvest these proceeds to purchase addi-tional securities long. Prime brokerage is



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limited in terms of the level of leverage it canprovide (though certain forms of prime bro-kerage financing allow leverage to exceedReg T limits), thus banks and hedge fundshave over the years developed creativestructures to provide greater levels of bor-rowing. Repurchase agreements (aka repo):Another source of hedge fund financing,particularly for those trading fixed incomeinstruments, is repurchase agreements, or repos. In a repo transaction, a hedge fundtypically delivers a security that it owns to alender as collateral in exchange for a loan.Repo transactions are generally of a fixed,short term nature ranging from one night toone month. With the perception of counter-

party risk currently at relative high levels,though, most repo transactions are of theovernight variety, limiting their value in thecurrent environment.

Total return swaps (TRS): Hedge fundscan also obtain financing through TRS facili-ties with banks. A TRS allows a hedge fund

to receive the leveraged total return of anunderlying asset or pool of assets. Bankloans and equities have historically been themost common security financed throughTRS. TRS transactions are typically struc-tured in such a way that is tailored to thespecifics of the underlying asset pool. TRSfacilities in place around banks loans and

other types of collateral can be an attractivesource of term financing, though many of these have safeguards in place that allowthe bank to take away the financing if, for example, the market value of the collateralwere to deteriorate.

Secured credit line: A secured line of credit, though difficult to obtain at fair financ-ing rates in the current environment, is an-


other source of financing for hedge funds.This is typically structured as a committedrevolving line of credit that is renewable on aperiodic basis supported by certain assetsheld in the fund. A hedge fund who has ob-tained this source of financing has an ad-vantage in the marketplace today as it al-lows them to purchase assets with a longer duration with little fear of being forced to sellat the wrong time, though banks have in afew cases found ways to back out of thesefinancing lines.

Structured financing vehicles: The mostsophisticated hedge fund managers wereable to structure transactions to providelonger term financing for their portfolios.These vehicles, structurally similar to CLOs

or CDOs, were a creation of the leveragedeconomy, and are difficult to issue in thecurrent environment, since few investors arewilling to purchase their debt. Those fundsthat created these structures and purchasedportfolio assets with the proceeds have along term, stable, cheap form of financingfor their portfolios.

Derivatives: Derivatives of all kinds, includ-ing options, futures, and forward contracts,contain implicit leverage. As discussedabove, utilizing a relatively small amount of margin, these contracts allow the investor tocontrol a much larger level of notional as-sets. This is slightly different in the sensethat derivatives allow for leverage withoutthe fund having to actually borrow money tofinance their positions (off balance sheet).

E. Hedge Funds and Leverage...What CanGo Wrong?

We have addressed how hedge funds apply lev-erage, how investors can measure it, and howleverage is obtained. Let us now tie this all to-gether in an attempt to understand the practicalrisks of leverage in hedge funds. It is critical torecognize in what circumstances leverage canbe an appropriate tool used to generate attrac-tive returns and, on the flipside, how leveragecan interact with and feed on other risks, be-coming quite dangerous. To do so, we will lookat some real world examples.

It is also important to understand how much total leverage is at the disposal of the manager, to get a

handle on how much gas the manager can apply to the portfolio.


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To understand what can go wrong, we must firstlook at a typical leveraged hedge fund balancesheet.

On the right hand side of the balance sheet wehave the liabilities, known as the capital struc-

ture of the fund. In light blue, we have the in-vestor capital, or equity. At the top, in darker blue, are the financing sources, or debt. Thisfinancing could take the form of prime broker-age margin, a secured credit line or other creditfacility, as discussed earlier. In addition, theright side of the balance sheet includes shortedsecurities, since these are borrowed and thensold, representing a liability. In many cases, thecash obtained from the sale can then be used topurchase additional securities long. Derivatives,in orange, can be either an asset or a liability,

depending on whether the fund is long or short

the derivative. In a case in which the fund isselling credit default swap protection, for exam-ple, this would be a contingent liability of thefund (though in this example the liability movesto zero if default does not occur). In somecases, the notional value of derivatives can beof significant size relative to the overall size of the fund balance sheet.

On the left side of the balance sheet, the assetside, the largest blue box is represented by thesecurities held by the fund. Note that this box islarger than the light blue box on the right siderepresenting investor capital; this indicates that

the fund is using leverage, otherwise it wouldonly be able to purchase securities up to thevalue of the equity provided by its investors. Asmentioned, derivatives can represent either anasset or a liability on a funds balance sheet. Ina case in which the fund is buying protection onCDS, this would be considered an asset of thefund (though the asset value moves to zero if default does not occur). We also have cash andmargin. Margin is the collateral or haircut re-quired by a lender in order to extend credit. Itprovides a buffer for volatility in the assets beingleveraged. If the volatility or the probability of loss in these assets is high, larger margin levelswill be required. For example, a portfolio of gov-ernment bonds will require much less marginthan one of high yield bonds. Hedge funds arecurrently making every attempt to maintain the

least amount of margin with their lenders in or-der to minimize counterparty risk. This bringsus to the last piece of the asset side of the bal-ance sheet, which is cash. Depending on thestrategy, most funds will be able to hold somelevel of cash on their balance sheet. Hedgefunds have also been careful as of late in termsof where and with whom cash is held, again inorder to minimize counterparty risk.

An asset-liability mismatch is one of the mostserious problems that can occur with a hedge

fund, most notably in the context of liquidity and/or duration. Most often this mismatch is cou-pled with an increase in volatility and correlationin the market. 2008 was a year that saw manyexamples of this phenomenon.

Lets look at two funds, Fund A and Fund B.Here are the basic attributes of each fund:

Fund A

Invests in diversified long and short portfolioof 60-80 large cap equities, roughly bal-

anced but with a modest long bias

Portfolio is financed through prime broker margin

Has $100m in equity capital from 10 pensionfunds with long investment time horizons

Redemption terms are quarterly with 90days required notice before the redemptiondate


Derivatives (Off balance sheet exposures)

Financing Sources(Debt)

Assets Liabilities

Free Cash

Margin

Securities Investor Capital(Equity)

Table 5. The hedge fund balance sheet

[source: NEPC]


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Leverage is low at 1.3x (LMV/Capital), thefund has gross long assets of $130m

The fund is 130% long and 100% short

10% of the funds NAV is in cash

Fund B

Invests in a concentrated credit strategy with20 long stressed and distressed bond posi-tions and 10 short positions, including someequity index shorts and some corporatecredit index (CDX) buy protection

Cash positions are financed with prime bro-ker margin and derivatives are used

Has $100m in equity capital from two fundsof hedge funds

The two fund of funds who invest in Fund Bobtained their capital from several Swissdentists

Redemption terms are monthly with 30 daysrequired notice before the redemption date

Leverage is moderate at 3x (LMV/Capital),the fund has gross long assets of $300m

The fund is 300% long and 250% short

10% of the funds NAV is in cash

Now lets put each fund through a perfect storm,much like the one witnessed in the fall of 2008,with the following basic parameters:

Equity and bond markets sell off materially

Market volatility spikes

Correlation amongst similar securitiesspikes

Typically less liquid securities become im-possibly illiquid, with no bids Idiosyncratic risk increases

Default probability increases

Investors, particularly Swiss dentists, be-come very skittish and move to cash (cashis king!)


Which fund is most likely to be able to survivethis type of market? Fund A is diversified,trades liquid securities, uses little leverage, andappears to have a stable capital base. Fund Bis quite different. First, the latter fund is concen-trated with only 20 longs and 10 shorts. With$300 million invested across only 20 long posi-tions, the average position size is $15 million, or 15% of NAV (equity capital). Secondly, the fundhas significant basis risk between its long andshort positions.

This is a problem in that the long and shortbooks may behave very differently. Conceiva-bly, over any particular period, the fund could,for example, lose money on its longs and alsolose money on its shorts. Thirdly, the funds 3xleverage is obtained through prime broker mar-

gin and repo without built-in term structureGiven the nature of the assets, less liquid dis-tressed securities, it is questionable as towhether a prime broker would in the current en-vironment provide financing up to 3x, but letssay this is possible for the sake of argument.

Here is how things might unfold:

Fund A

The perfect storm hits but the fund remainsflexible; it can reduce, add, or eliminate po-

sitions. The fund suffers idiosyncratic eventsin 3 positions that are down between 30%and 50%. The fund eliminates two of theseand adds to one. The vast majority of thefunds long and short positions are financedwith cash. Most of the positions financedwith margin turn out to be some of the lessvolatile positions in the portfolio; the fundreceives margin calls on a few of these posi-tions but easily meets these with cash fromother positions it sold.

The investors of the fund are concerned, butthe manager is able to explain that it seesthe current market conditions as a tempo-rary aberration, that the fund remains verynimble, and that most of the losses are markto market only and not realized. Most inves-tors seem to be on board, with only 8% of fund capital requesting withdrawal for nextquarter.


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what is lost on the long side. Within 4weeks, the fund has lost 18% of its value,losing 25% on the long side and gainingonly 7% on the short side.

The funds future is uncertain and it may be

doomed. The fund has lost 18% of its valuebecause it applied significant leverage to arisky, illiquid space and its portfolio had ma-terial imbedded basis risk. Due to pressurefrom financing providers and investors look-ing to redeem, the fund has no flexibility tohold its slumping positions, much less buyinto opportunities. The prime broker isloathe to continue to finance the fund and,although leverage is now down to 1.5x(LMV/Capital), this number may be forceddown further, especially if markets dont turn

around. The prime broker is also watchingto see how the redemption situation of thefund evolves, and most likely will shortly pullall of the funds financing.

The table below summarizes a list of key factorsthat dictate the appropriateness of the leveragelevel used, coupled with examples where vari-ous factors are combined to create differingscenarios. Many hedge funds have lost mate-rial amounts or even all of their value by apply-ing leverage to particular assets or a portfolio of assets in an inappropriate manner, such as inthe dangerous scenario above (for instance, inthe case of hedge funds run by Bear Stearns).Excessive growth of the capital base is alsodangerous as it creates a situation where themanager must deploy assets, potentially grow-ing the balance sheet using lower convictionideas. In each case, the combination of factorscausing the crisis has been unique. Finally, andperhaps most importantly, manager hubris hasalmost always been a factor in the demise of hedge funds. There is no doubt that the humanelement is a critical piece of analyzing hedgefund risk, making qualitative analysis, such asunderstanding the incentives of the investmentprofessionals running a hedge fund, as impor-tant as understanding the quantitative aspects.


The fund is hurt on the long portfolio but theshort portfolio moves up, as expected. Thefund loses 4% over the course of a month,down -12% on its longs and gaining +8% onits shorts.

Though the fund performed poorly during thestorm, it will live to fight another day, andmay even be in a position to pick up somebargains in the beaten up market. Its financ-ing providers are comfortable with the cur-rent portfolio and continue to extend credit tothe fund. Investors are not happy about los-ing money, but still believe in the fund.

Fund B

The fund is in a dire situation. It suffers idio-syncratic events in 6 positions that are downbetween 30% and 60%. The fund receivesmargin calls on these and other positions. Ituses cash on hand to meet a few margincalls and attempts to sell some of its moreliquid positions to meet the others, but in themarkets flight to quality there is a lack of bids for their positions and prices gap down.The fund lacks flexibility and is forced to sellpositions at fire sale prices, even though itbelieves these will ultimately recover, in or-der to meet margin calls. Some securitiesare impossible to sell as there are absolutely

no bids.To make matters worse, the funds investorshave learned of the funds woes and haveasked the manager to return 50% of thefunds capital before the 30 day redemptiondeadline expires. These funds of fundshave their own pressures, as the Swiss den-tists have lost confidence in them and areasking for their capital back. In a panic toraise additional capital, the manager contin-ues to sell positions, realizing significant ad-

ditional losses.The storm causes many of the funds longsto gyrate wildly, losing a great deal of value,while other positions show little price discov-ery and liquidity and prices appear to fluctu-ate less. Generally, the funds positions aremuch more volatile than the manager antici-pated. In the end, the short book does fairlywell, but unfortunately gains much less than


11/11

11Leverage, Hedge Funds, and Risk Summer 200

NEPC, LLC is an employee owned, full service investment consulting firm. Founded in 1986, NEPC is one of the largest

independent firms in the industry. We are headquartered in Cambridge, Massachusetts and have additional offices in Detroit, Michigan; Charlotte, North Carolina; Las Vegas,

Nevada; and San Francisco, California. You can reach us at (617) 374 1300.

www.nepc.com

F. Conclusion

Hedge funds will continue to use leverage toenhance their alpha generation capabilities, andwhile we do not believe that leverage is a re-quirement, we do think that those funds that can

obtain and use it appropriately may have a com-petitive advantage going forward. Indeed, re-cent market turbulence highlights the impor-tance of focusing on high quality hedge fundfirms that have developed well-structured, ro-bust investment processes to address both in-vestment risk and operational risks that can eas-ily translate into investment risk, all whileachieving their investment objective through avariety of market environments.

For many of these managers, leverage will re-

main an important tool for achieving their returngoals. Now more than ever, investors must takea prudent and thoughtful approach to assessingnot just leverage, but a variety of risks imbeddedin hedge funds, and they must be prepared toaddress these complex topics directly with man-agers. Hedge fund managers, for their part, arerealizing that it is also in their best interest to besure that investors fully understand these risks,and that both sides should not focus solely onthe reward side of the equation.

Table 6. Factors that determine appropriatehedge fund leverage levels

High Moderate LowHigh

ModerateLow

HighModerate

Low

HighModerate

Low

HighModerate

Low

HighModerate

Low

HighModerate

Low

HighModerate

Low

HighModerate

Low

HighModerate

Low

HighModerate

Low{source: NEPC] Green = Acceptable

Yellow Use cautionRed Dangerous

Leverage Level

Positionconcentration

Asset volatility

Term of financing base

Portfolio basisrisk

Asset credi t

quality/price

Asset duration

Asset pricecorrelations

Asset liquidity

Asset pricediscovery

Stability of capital base

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