Beware the use of leverage in turbulent and volatile markets

As leverage becomes increasingly difficult in the current market turmoil, Stephen Quigley and Jamie Wynn-Williams look at the challenges facing hedge funds that rely on this technique to generate high returns

Hedge funds are becoming increasingly limited in their use of leverage by the willingness of creditors to provide the needed liquidity.

Leverage is optimal if managers identify the right opportunities for making the bet. "[Leverage] increases exposures to the desired price direction either by buying long or selling short and is therefore risky, particularly if the bet went wrong," says Daniel Chi-Hsiou Hung, lecturer in finance at Durham University's Business School.

Explicit leverage is easily monitored. An understanding of the fund's position is also necessary to clarify the extent of embedded leverage. "If a fund is operating at the maximum levels of leverage permitted by its prime broker, then an increase in the margin requirement - usually because of an increase in the perceived riskiness of the strategy - means assets must be sold to generate sufficient cash," says Sheldon MacDonald, senior investment analyst at Nedgroup Investment.

Hedge funds have a symbiotic relationship with prime brokers. Both industries are highly competitive. In efforts to lure new clients, credit would have been dangled as a carrot by prime brokers. They have now scaled back their risk exposures given the tight market liquidity and charge higher financing spreads.

Facilitating leverage represents a source of lucrative revenue for prime brokers compared with the increasingly competitive business of providing a bundled package of services. But at the same time hedge funds are both scaling back and looking around for multiple brokers with liquidity. Funds are also cautious about counterparty risk and are examining the liquidity of their prime brokers in an unprecedented manner.

For their part prime brokers are taking more care to examine the exposures and risks of hedge fund clients, with some closely monitoring situations and ready to pull the plug if positions become untenable.

Nedgroup's MacDonald believes the overall illiquidity and reluctant inter-bank lending is dramatically impacting credit lines extended (or not) to hedge funds.

"Bank illiquidity generates a vicious cycle. The perception of riskiness usually increases because the assets utilised in the hedge fund's strategy become more volatile mostly on the downside," he adds.

Selling assets into an illiquid market drives already illiquid asset prices lower, requiring further selling to generate cash. Some of the recent high-profile hedge fund failures unfolded in precisely this fashion when highly leveraged margins were called. Forced selling of assets into a market with no appetite further decreased prices in a downward spiral. Leverage introduces negative asymmetry. So a three-times leveraged fund is likely to lose more than three times the amount it would have lost had it been unleveraged.

Excessive and poorly understood leverage makes people nervous, says MacDonald.

In managing funds of hedge funds, MacDonald sees leverage as a valid, value-adding tool, but only in skilled hands. "We spend a great deal of time and effort finding managers who can resist the temptation of excess leverage when necessary, but also harness it correctly when appropriate," he says.

Leverage is a tactical activity that is very effective in enhancing strategy value and thus will remain attractive to managers, Durham University's Hung adds.

"When using derivatives it depends on what types are being used. The amount of risk in futures contracts, for example, depends on what proportion of the investment is placed on the margin and the uncertain price movements after the bet is made," he says.

Some hedge funds seek to be neutral in systematic risk. This can be a moving target and difficult to maintain. Others trade on options where the leverage costs are impacted by the underlying asset price volatility. This can be substantially higher due to volatility clustering during market downturns.

The variation in the borrowing cost also introduces time-varying risk. Hedge funds typically leverage assets slightly higher than Libor.

This can deteriorate the profitability of the leverage position. In the case of carry trades which involve the borrowing of foreign currencies, the uncertainty of the level of exchange rate risk gives an additional time-variation in risk exposures.

MacDonald believes it is essential to consider the amount of gearing used in any hedge fund. Investors should be told what the level of leverage used is, how risk is monitored and controlled and what limits are set on the use of leverage. MacDonald is advocating improved transparency from funds on this issue and thinks if funds do not provide this information it could be a topic for regulation in future.

Disclosure essential

As long as the funds disclose risk, leverage is fine, according to Mike Newell, partner, and David Will, senior associate, at law firm DLA Piper.

There is an issue where there is not enough disclosure. Managers need to disclose more. Generally managers do not go into detail on the amount of leverage they use or even what they mean by leverage, according to Will and Newell. Both think this could be a subject for more self regulation.

Olivier Le Marois, CEO at risk management company Riskdata, agrees with DLA Piper. He says the main problem is disclosure of risk. "Between 2003 and 2007 there was a period where volatility in the market was exceptionally low so this led some managers to massively increase their leverage in order to boost returns. However, when we turn back to the very shaky environment of 2007, these same managers were forced to dramatically deleverage, leading to a liquidity squeeze and related massive losses," concludes Le Marois.

"More leverage means more risk. But if risk stays at a reasonable level and is transparent, it is not a problem," he says.

"Leverage is hard to regulate because it leads to questions like what is leverage and how you define it. The true issue is not to get transparency on the leverage in a portfolio, but to get it on the risks. For an investor what is not acceptable is to think he is invested in a very safe asset only to suddenly wake up with a 40% draw down (because of leverage). To have no transparency on risk is unacceptable," believes Le Marois.

Leverage has been an intrinsic part of the financial engineering the world has experienced over the last decade. The results are all too familiar to Mohammed Hanif, chief investment officer at Insparo Asset Management. He is seriously considering consigning leverage to the dustbin until the next bull market.

"I think the role of leverage needs to be fundamentally re-examined," says Hanif. "Classic use of debt (leverage) in the capital structure can optimise a business's balance sheet and provide room for a company to operate beyond its equity resources and achieve a greater return for its shareholders. This is accepted as the optimal balance sheet."

Hanif suggests the application of leverage to investment portfolios has been so suboptimal as to border on the abusive, with some emerging markets managers reportedly leveraging Nigerian treasury bills 20 times. He also cites the example of an asset-backed security structured investment vehicle managed by a private equity company leveraged up 28 times.

"The investment world seemed to have forgotten that leverage magnifies not only returns but also any losses. The hunt for marginal yield ignored the associated increases in operational risk. Who owns your assets when your prime broker goes bust?" asks Hanif

Default in prime broker agreements that seemed benign and were ignored have come to haunt many fund managers. Any trade ideas worth doing involving leverage became too crowded, increasing the inherent risk even more.

Two to leverage

"It takes two to leverage," adds Hanif. "Irresponsible lending against risky collateral at low haircuts makes the banks as culpable as the investment managers that accept it. In recent months many business models have been shown to be flawed. The underlying investments were and even today remain fundamentally sound, but the funding framework when tested, ie the withdrawal of leverage, was about as sound as Northern Rock's," says Hanif.

Leverage is being withdrawn and the speed and aggressiveness with which it has been pulled has surprised many asset managers, comments Hanif. This creates a self-fulfilling prophecy.

"Returns will normalise. Time for the real risk managers to stand up. Those who have relied upon leverage will be found wanting. At Insparo the philosophy is to employ little if any leverage," notes Hanif.

Don Brownstein, chief investment officer and CEO at Structured Portfolio Management, says leverage is something that multiplies risk for risky assets. He believes managers should be very careful when using it. The risky asset can change dramatically in a non-linear fashion in terms of spreads, he notes. If a manager decides to have a lot of them, the fund will not be in a healthy position.

"How much should you leverage? The answer depends on what other things you are doing, the kind of assets you are considering leveraging, whether those assets have any margin calls associated with it, what the term of leverage is and what the counterparty associated with the leverage is. So there are all sorts of questions that are part and parcel of making use of leverage," says Brownstein.

Structured Portfolio Management takes a conservative view on the use of leverage, confirms Brownstein. Even when leveraging assets under the best of conditions, liquidity could be limited. He believes people got into trouble in the most recent credit crisis because they leveraged bonds that most experts at the time would have considered quite liquid instruments.

"Unfortunately the assets were leveraged a bit too much and they suffered the consequences - for example, Carlyle Capital. The point is using maximum leverage or anything approaching maximum available leverage puts you in a position that you have to rapidly delever," says Brownstein.

Between 2004 and 2006 there were varying levels of inflation in the capital markets, particularly in residential real estate, explains Brownstein. In this case what happens is that spreads tighten and managers are tempted to use leverage as a way of easing their return hurdles. As spreads tighten people increased leverage.

"Are they happy or unhappy about what they did in that period? I think some of them are no longer in existence. Has leverage returned to the levels that they were pre-subprime? Not on your life," adds Brownstein.

Leverage varies dramatically over time. According to Brownstein, one of the odd things about leverage is that if a manager is cautious when owning limited liquidity assets, as liquidity becomes a problem he might have greater constraints imposed on them.

Managers feel most comfortable leveraging the most liquid assets, he notes. However, the principle of leveraging a multiplier of the other risks in an asset works no matter what those other risks are.

"In a liquidity crisis of the sort that we had in mid-March, under those conditions liquidity itself is the problem. Nobody is willing to lend to anybody else even if they have the money," concludes Brownstein.

Despite the fact that the US, UK and European central banks tried to find ways to inject liquidity into the banking system, the system was not prepared to pass that liquidity on to users. So risk now comes in two parts: no liquidity to lend to anybody, and money available to some but not passed on to those who need and want it.

"During the crisis in March the prime brokers were extremely concerned about leverage. They were worried that client X would fail and counterparty X would fail and what the consequences would be. Unfortunately it wasn't perfectly apparent what everybody else's risk position was," Brownstein explains.

The calmer the capital markets are in the next year or so the less pressure there will be for regulation. In the US where there is a presidential election campaign, it is now a good time to be backing more or less regulation, depending on which voters a candidate is trying to attract. "In general I think that leverage will be more regulated. I am not sure how much it will apply to hedge funds though," he concludes.

- Related articles: Lead story, page 1; Tete-a'-tete, page 13; Risk management, pages 31-32.