25/05/2011 Author: Will Wainewright

The leverage principle

Last week’s report by HFR that leverage levels at hedge funds have dropped will raise questions among those in the industry expecting a return to higher levels of gearing. But is this a sign of a more cautious industry, or just one adjusting to more stringent investor requirements?

The reduction in leverage levels recorded by Hedge Fund Research (HFR) last week – its research suggests a decline from 1.27 to 1.10 times investment capital in the last year – surprised some. Yet the main reason for the surprise was not the direction of the move, although some prime brokers maintain that leverage levels remain higher than HFR’s latest figures, but the fact there had been a significant shift at all. Leverage levels had been thought by many to be stuck in something of an impasse.

Consensus holds that leverage in the industry had climbed back up after dropping off sharply during the financial crisis – but is still some way off pre-2008 levels. Chris Barrow, global head of sales for HSBC Prime Services, says the latest drop doesn’t entirely reflect what he has seen. “The firms we are engaged with, primarily large European hedge funds running equity strategies, tend to be an average of 1.2 to 1.5 times leveraged. I don’t see that changing in the near future.”

Other measurements of leverage have come up with different findings. The latest Bank of America Merrill Lynch Fund Managers Survey says hedge funds are “risk-on”, with 1.53 gearing – the highest since before the crisis. Many think somewhere in between the two estimates is probably the case. But do any in the industry foresee a situation where leverage goes back up to levels seen before the crisis?

“Not unless confidence returns to the global economy – and fast,” says an employee at one leading prime brokerage.
“It is all market-dependent. If anything changes drastically in the macro picture – uncertainty in the Middle East, US growth, sovereign debt – then you could see it rise. But investors just don’t want to see high risk levels.” The stringent rules on leverage demanded by Ucits funds will also add to downward pressure on levels as more rush to adopt the wrapper – and some Ucits standards even bounce back to the traditional offshore model.    

Hedge fund manager Aram Fuchs, founder of New York fund Fertilemind Capital, points to another factor still putting downward pressure on leverage levels. “If you look at all the international banking regulations and then the country-specific ones, they’re all demanding that the banks use less leverage. So the banks are going to give out less debt to their hedge fund clients.”

Barrow agrees this has also played a part. “Increased capital adequacy provisions and new regulations are adding constraints,” he says. Barrow hopes that bigger banks, like HSBC, with the stable balance sheet cover they offer, are best placed to capitalise in this regard.

So if leverage looks unlikely to rise significantly any time soon, how do prime brokers, for whom leverage is a central revenue stream, prepare for a situation in which levels remain historically low?

“The more leverage the more beneficial, obviously, for prime brokers, but the industry does not rest on it,” explains on prime broker, who says his company has radically diversified its offering since 2008. Other revenue streams, including the handling of Delta One, contracts for difference (CFD) and futures trades, help ensure a less singular approach. “Of course, if leverage went to zero we would all have a slight problem,” he admits.

Formed in the wake of the crisis, Barrow says HSBC’s prime services division also realises the importance of a wider service. “You prepare for a drop in leverage by having strong and deep relationships with your hedge fund clients across a number of products. Then you are not exposed just to the borrowing requirements, or shorting requirements, from a hedge fund to make money.”

Prime brokers appear to have positioned themselves so they are not reliant solely on the leverage business – a wise move if more hedge fund managers share the views of Fuchs. “Leverage just amplifies risk,” he says. “I think what we’ve learned from the global financial crisis is that humans are not that good at predicting the future. If you make your bets with borrowed money you really have to be accurate – so if people are using less leverage for their bets there’s going to be less volatility in the economy.”

A lot of managers – particularly those in relative value and market neutral strategies, who, prime brokers say, are currently levering up funds as they predict strong returns – may not agree. But it certainly appears that the industry – prodded by investors and their own risk aversion – will remain a low leverage one for some time yet.

Leverage: the State of Play
Source: HFR

- Across all hedge fund strategies, average standard leverage decreased from 1.27 to 1.10 times investment capital.

- Average margin to equity fell from 17.13% to 16.98%.

- Approximately a third of hedge funds do not typically use leverage – a slight increase.

- Over half of all funds use leverage of between one and two times their investment capital.

- Larger funds usually use more leverage: 23% of funds with assets of more than $1bn under management use leverage of between two and five times investment capital.