REPORT: Hedge Fund Leverage

Time-varying exposures and leverage in hedge funds

Style analysis shows that as market conditions change so do the investment strategies of hedge funds. It also provides a simple indicator of hedge fund leverage that varies over time. The indicator suggests that leverage tended to be high in 1997-98 but lower more recently.

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NEWS: Will Hedge Funds Get Squeezed?

Dangers:

Leverage--One assumption prevalent among the media and "real money" (i.e., nonleveraged) fund communities states that sharply higher U.S. bond yields could raise the cost of leverage. That, in turn, could mean a credit crisis and a shakeout among hedge funds -- similar to the troubles precipitated by the meltdown of Long Term Capital Management in 1998. The idea is that the Fed could inadvertently trigger such a meltdown by continuing to hike rates, eliminating the "easy money" that has aided the growth of the hedge funds.

Fake returns-- The Hedge Funds Research (HFR) database, which covers up to a third of the industry in a survey, found that by 2004, the number of funds it reviews had grown nearly fivefold, to 3,671, over an eight-year period. That compares to overall industry estimates of 8,000 to 10,000 worldwide and 6,000 to 7,000 based in the U.S., according to the Securities & Exchange Commission. Assets under management grew more than sixfold, to $327.7 billion, over the same period, according to the HFR's smaller survey sample, which aligns with $600 billion to $1 trillion in assets estimated in a report from the Bank for International Settlements (BIS).

Lending--The quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices from the Fed's board of governors, last published in January, takes a comprehensive look at the overall lending climate in the U.S. While it contains no specific reference to hedge-fund borrowing, it offers insight into the environment since the Fed embarked on raising rates last summer. The Fed reported that both domestic and foreign banks eased their lending standards, tightening yield spreads, loosening restrictions, reducing costs, lengthening terms, and increasing maximum loan size. This relaxation has come in response to increased competition from nonbank lenders, greater depth of secondary markets, and "a less uncertain economic environment." The report suggests that the impact of Fed policy has been far from restrictive and that further "measured" rate hikes will have a similarly benign impact on issuance of credit unless monetary policy moves well beyond a "neutral" stance. Moreover, this crossover from tight to easy credit is comparatively youthful in cyclical terms -- since the start of 2004. The most recent similar loose-money era ran from 1992 to 1998.

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