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.

MORE on Page 59 of BIS Report

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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NEWS: NYT-If I Only Had a Hedge Fund

March 27, 2005
NEW YORK TIMES JENNY ANDERSON and RIVA D. ATLAS

To critics, the frenzy has a very familiar ring. A flood of capital to the latest investment fad. Spectacular accumulation of wealth in a short time. New ventures created easily and often. Those, too, were the hallmarks of the dot-com boom, and, as everyone knows, the bursting of that bubble was far from pleasant. The stampede to hedge funds, some people fear, will be no different.

"It is completely obvious that this will end badly - for the firms, investors, everyone," said Seth Klarman, founder of the Baupost Group, which manages $5 billion. "No area of financial endeavor is immune from the effects of competition."

The numbers are mind-boggling: 15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. By contrast, assets in mutual funds grew at an impressive but much slower rate, to $8.1 trillion from $1 trillion, during the same period. The number of hedge fund firms has also grown - to 3,307 last year, up 74 percent from 1,903 in 1999. During the same period, the number of funds created - a manager can start more than one fund at a time - has surged 209 percent, with 1,406 funds introduced in 2004, according to Hedge Fund Research, based in Chicago.

...Whether the hedge fund boom is a bubble may still be open to debate. But it is certainly not alarmist to wonder about the consequences of such torrid growth, built as it is on the leverage that banks provide managers to double or triple their bets. The Federal Reserve seemed concerned enough last fall, when it set up a group to examine what systemic risks had been created by the explosion of entrants into the market and the aggressiveness with which Wall Street was welcoming them.

...Perhaps topping the list of concerns is the proliferation of funds of funds, pools of hedge funds that are meant to lower risk but that also come with another layer of fees on top of what standard hedge funds charge. By the end of last year, assets in funds of funds had soared to $359 billion, from $84 billion just four years earlier. Traditionally, investors have needed a minimum of $1 million to get into a hedge fund; with the newest funds of funds, investors with as little as $25,000 to spend can gain entree...

Many industry veterans say the party will continue, partly because of the shift in who invests in hedge funds. As recently as 2000, hedge funds were almost exclusively for the very rich. Now institutions want a piece of the action. Pension funds and other institutions are expected to invest as much as $250 billion in hedge funds over the next five years, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That would ultimately account for half of all money flowing into hedge funds.

But as the pension money comes in, hedge fund returns are likely to go down, as fund managers adapt their strategies to suit the new clientele. Pension funds prize predictability over outsized returns; the average pension fund is looking to make just 8 percent, net of fees, on its hedge fund investments, the Casey Quirk report concluded. That is a far cry from the 25-percent-plus returns generated by rock-star managers like Mr. Soros and Michael Steinhardt.
A possible check on hedge funds is the simple fact that while anyone can start one, the industry has a high casualty rate - especially for the smallest funds, which struggle to attract and keep investors. Untested managers whose returns languish often see their capital flee and are forced to shut down.

"There are very low barriers to entry but very high barriers to staying in business," said Philip Duff, chief executive of FrontPoint, a $4.3 billion hedge fund, citing the average annual life of a hedge fund of 3.5 years. "That's problematic for investors," he said - particularly institutional investors who do not relish moving money around..

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Lessons from the Collapse of Long Term Capital Managment

David Shirreff:

Barings, the Russian meltdown, Metallgesellschaft, Procter & Gamble, LTCM. These are all events in the financial markets which have become marker buoys to show us where we went wrong, in the hope that we won't allow quite the same thing to happen again. The common weakness, in these cases, was the misguided assumption that 'our counterparty and the market it was operating in, were performing within manageable limits.' But once those limits were crossed for whatever reason, disaster was difficult to head off.

The LTCM fiasco is full of lessons about:
Model risk
Unexpected correlation or the breakdown of historical correlations
The need for stress-testing
The value of disclosure and transparency
The danger of over-generous extension of trading credit
The woes of investing in star quality
And investing too little in game theory.

The latter because LTCM's partners were playing a game up to hilt.


John Meriwether, who founded Long-Term Capital Partners in 1993, had been head of fixed income trading at Salomon Brothers. Even when forced to leave Salomon in 1991, in the wake of the firm's treasury auction rigging scandal (another marker buoy), Meriwether continued to command huge loyalty from a team of highly cerebral relative-value fixed income traders, and considerable respect from the street.

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Bill Gross on Hedge Funds: Turning Lemons into Lemonade

Horatio Alger stories which allude to finding the proverbial toy at the bottom of the manure pile or turning lemons into lemonade are a reflection of the American dream – rags to riches, something from nothing, a pot of gold at the end of your own personal rainbow. Still while dreams and wishes upon a star do come true for some of us in this Jiminy Cricket world, there can be a cost to fantasies ungrounded in reality and everyday common sense. In the world of money we have our oft-cited historical examples: tulips, portfolio insurance, NASDAQ 5000. Pop went these bubbles and the savings for that matter of investors lured in at or near the top. It’s a story of the ages, an endless ticking of the human metronome setting a cadence swinging from fear to greed then back again. What isn’t always obvious, however, and what makes the game go on and on is that the lure morphs into a different shape, sometimes during the same generation of investors. A good fisherman knows that if the fish aren’t biting you change the bait and a good salesman knows that if you can’t sell lemons, push the lemonade.

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Watch Out For Misleading Track Record and Declining Returns

Myths and Realities Report, Bernstein Wealth Management:

• The average hedge fund broke even in 2001.
• Over half the top quartile funds in 1999 dropped to the bottom quartile in 2000.
• Profit potential is declining dramatically.
• High fees and tax inefficiencies of fund of funds make them bad investments

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Hedge Fund Fraud

The hedge fund, called KL Financial Group, had assets of more than $200 million. It has told investors that it ran out of funds because of heavy trading losses, according to attorneys and clients involved in the fund. The SEC plans to file a temporary restraining order this week to freeze any assets left in the fund, according to people familiar with the investigation.

From:
Tony Hedge Fund Runs Aground
Palm Beach's Wealthiest InvestedIn KL Financial, but Money Is Gone;Talk of the Country Club Crowd
By ROBERT FRANK Staff Reporter of THE WALL STREET JOURNALMarch 2, 2005; Page C1

Investors need to become much more sceptical about hedge funds

WHEN an opaque investment fund that does no hedging (in other words, it takes no positions designed to offset other bets) calls itself a hedge fund, charges the sky-high fees of a typical hedge fund and has wannabe customers banging on its door, it is time to ask: what is going on? The rise of hedge funds is not new. But the funds continue to grow strongly, attracting billions in new money and piquing the interest of investors who, until recently, would never have considered them. Among the new customers are some of America's biggest public pension funds, whose beneficiaries almost certainly have no idea that some of their savings are about to be poured into such murky investments.

MORE FROM GOOD ARTICLE FROM THE ECONOMIST

Great Source for Academic Papers

Hedge Fund Research Initiative

The Yale ICF hedge fund research initiative is a program to actively investigate hedge funds as an asset class and the range of issues related to their management. The current research agenda includes:
Performance: risk, returns, styles, timing metrics and survival.Management contracts: valuation, incentives.Strategies: relative-value, momentum, stale-prices.Role in the capital markets: Asian crisis, price formation, scalability of strategies.

Bill Gross's Take: Good salesmen know- If you can't sell lemons, sell lemonade

A good fisherman knows that if the fish aren’t biting you change the bait and a good salesman knows that if you can’t sell lemons, push the lemonade.

So it is with today’s craze for hedge funds.

[more]

The Big Dangerous Bet... good warning from The Economist

WHEN an opaque investment fund that does no hedging (in other words, it takes no positions designed to offset other bets) calls itself a hedge fund, charges the sky-high fees of a typical hedge fund and has wannabe customers banging on its door, it is time to ask: what is going on? The rise of hedge funds is not new. But the funds continue to grow strongly, attracting billions in new money and piquing the interest of investors who, until recently, would never have considered them. Among the new customers are some of America's biggest public pension funds, whose beneficiaries almost certainly have no idea that some of their savings are about to be poured into such murky investments.
[more]

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Overstating Returns

Like so many bubbles, the hedge fund bubble is further fueled by bad numbers. The telco/dot.com bubble had accounting gimmicks and stock analysts who provided poor and misleading market information. The hedge fund bubble is fuel by statistical biases in the index the inflate returns:

Fri Feb 11, 2005 07:33 AM ET By Steve Hays

GENEVA, Feb 11 (Reuters) - Hedge fund indexes strongly overstate the industry's investment success and far too much money is being drawn into the funds as a result, with possibly dire consequences in the future, a leading U.S. academic said.

"Between 1998 and 2004 there has been enormous growth in hedge fund assets to about $1 trillion and since they are typically leveraged their buying power is much greater. Hedge funds often account for the lion's share of trading on the New York Stock Exchange," Burton Malkiel, professor of economics at Princeton University said....

Between 1988 and 2003 the Van Global Hedge Fund Index showed compound returns of 15.9 percent, compared with 5.9 percent for the MSCI world equities index and 2.3 percent for the S&P 500 stock index...

But Malkiel said the freewheeling nature of the hedge fund business, with their freedom to choose whether to report performance results and which numbers to publish, compared with the obligatory quarterly reporting of U.S. mutual funds, injected a strong positive bias into industry databases...

Malkiel analysed hedge fund returns for backfill bias between 1994 and 2003 and found that with backfill these averaged 14.29 percent, but without backfill 8.45 percent - a 584 basis points difference in performance.

Another problem with hedge fund data is "survivorship bias" as they have a much lower survival rate before being closed down than mutual funds, meaning indexes tend to reflect the results of successful funds rather than poor-performing dead funds.
Of 604 funds in the TASS hedge fund database in 1996, some 480 had "died" by 2003.

Full article.

Full academic paper.

INTRODUCTION

The hedge fund bubble seem to fit the classic arc of a too many people jumping in to take advantage of the newly perceived benefits of a financial arrangement, saturating the market and thus leading to lower returns.