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December 4, 2007
Leverage plus mayhem - a touch of midsummer madness or a midsummer market's dream?
“In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.” Wikipedia.
Never before have hedge fund investors had such cause to focus on the leverage embedded in the strategies they follow. Leverage levels have of course always been a key due diligence criterion in the investment process but the fall-out from the collapse of the US sub-prime market has brought this issue to the top of the pile.
Some of the dangers of excessive leverage have been known for as long as traders have bought and sold goods on margin. And leverage-related collapses (frequently forward/futures related) have punctuated markets since the South Sea Bubble. Much more recently, it was this element of futures trading that led The Economist in 1981 to describe London’s anticipated financial futures market (Liffe) as a casino, going so far as to run an image of a roulette wheel on the magazine’s front cover.
It is arguable that the growing importance of Liffe and of other financial futures exchanges around the world, diminished fears about the impact of leveraged positions on turbulent markets (although the theory that the 1987 crash was prompted by excessive speculation in index-options did provide something of a wake-up call).
In the hedge fund context this lack of understanding seems to have supported a body of academic/scientific opinion that held that since leverage was not actually dangerous as and of itself, so therefore highly leveraged investments based on ‘certain’ arbitrage positions were the way forward since all that leverage was doing was to magnify the profits from the trade.
Remember 1998 and Long Term Capital Management? In the end, LTCM‘s emerging market debt arbitrages turned out to have been correctly positioned but short-term adverse market conditions acting on the high leverage employed meant the manager couldn’t hold the position as his lines of credit squeaked and then ran out, creating that notorious and catastrophic outcome.
Unfortunately, the boffins at LTCM seemed to have forgotten the maxim coined in the early 1980s by one of the original ‘Market Wizards’, Larry Hite, who pointed out that, “You can’t win if you don’t bet but you can’t bet if you have no money”.
The post sub-prime lessons are equally as clear as those arising from the LTCM debacle. LTCM taught us to remember that even if one ‘knows’ the outcome of a trade, the road to that outcome may be filled with pitfalls. Today’s markets have taught us (or should have done) that (high) leverage is a function of credit and sources of credit may quickly dry up when the going gets tough. The obvious, but rarely considered, corollary to this is that a highly leveraged portfolio is therefore under the control of the provider of credit - bank, prime broker, both - rather than the manager.
For proof of this assertion, one need look no further than the mid-August reports of newspapers of Goldman Sachs’ multi-billion dollar bail-out of a couple of its hedge funds. Or HBOS’s bailout of Grampian. Or Sowood’s collapse (to the embarrassment of Harvard Management Company). Or …
In these and other contemporary cases of Eddie Cochran’s, ‘Summertime Blues’ (“… about working all summer, just to raise a dollar …”), the unvarnished issue is that if the provider of credit shuts down the lines or, alternatively, refuses to support a bail-out then there must be immediate deleveraging: in other words an immediate forced-sale of assets and closure of positions. And, inevitably, such a fire sale - for example of a portfolio of long and short equity positions - will exacerbate rather than improve the portfolio’s problems. The forced sale of ‘longs’ makes stock cheaper and thus potentially more desirable to the fund manager were he to have a free hand to make his own trading decisions; and vice versa regarding the ‘shorts’.
That said, conservatively run and conventionally structured long/short equity portfolios are not particularly exposed to such pressures given they are rarely geared more than one and a half times. The real impact is felt at higher levels of apparent investment sophistication: credit arbitrage, emerging market debt arbitrage, statistical arbitrage, levered strategies involving either investment in, or backed by CDOs or Asset-backed securities (and also, of course, in the private equity sector). Here, high leverage is implicit to the strategy and, at least in the past, has been seen by some managers as a marketing plus.
This, for example, is the first line of the self-description of one of the most successful ABS funds of recent years: “XXX is a fixed income performance fund designed to generate returns by applying leverage on the highest quality portion of the Asset-Backed Market …Leverage is applied up to a maximum 20 times”. This is a big fund and 20 times the billions of dollars under management is awe-inspiring.
But this article is not a diatribe about leverage - far from it. But it is a call to investors to read the small print and to question how leveraged their selected managers are and, more importantly, whether in the future, the managers’ portfolios and indeed their investment approaches are going to be changed out of all recognition.
For if managers used to employing high leverage cannot immediately call upon friendly and flexible credit lines when investment opportunities present themselves, their continuing viability let alone their appeal to investors must be called into question. And if investors do pull-out, the result must be a bear market in highly leveraged hedge fund strategies that carries with it the chance, as all bear runs do, of infecting related sectors - in this case the hedge fund industry as a whole. In these circumstances, investors (to quote Bridget Jones) may well “be left with the personal confidence of a passed-over British Rail sandwich.”
Declining popularity of certain types of hedge funds is not unknown. Only a few years ago convertible arbitrage managers moved from the top of the Premier League to face relegation. This fall from grace was also caused by an inability to trade but in this case occasioned by a drying up of investible assets rather than of the means to trade them. Furthermore, the convertibles squeeze was an isolated event rather than the product of something approaching a global panic so there’s not much consolation to knowing that convertible arbitrage, as a strategy is returning to favour.
In my view that, there will be a shortage of credit for quite a while and in fact we may never again see the levels of enthusiasm to provide cheap credit that characterized the build-up to the sub-prime bubble. And if credit is much tighter so the opportunity to magnify small returns from sophisticated strategies will evaporate (and may well already have done so). The issue for now, is to ensure as much as is possible, that actual and potential investors continue to understand the hedge fund industry is not a composite whole in the way that traditional equity investment can often be viewed and in the way that hedge fund indices sometimes suggest.
Some managers have been largely unaffected (at least directly) by the sub-prime crisis, some have been hurt and some (who chose the short the sub-prime market) have made a veritable fortune. As Shakespeare has it (Twelfth Night), “Why, this is very midsummer madness.”
-By Nigel Blanshard-
Published in Hedge Fund Review - Issue 83
Posted by su at December 4, 2007 11:21 AM