Unstructured Finance

Hedge funds love affair with leverage still on hiatus, for now

October 5, 2012

By Katya Wachtel

Last year was a sorry one for the $2 trillion hedge fund industry, when funds lost 5 percent on average. This year managers are doing better, up more than 5 percent for the year, according to the latest tracking data.

But those returns are a far cry from the 16.4 percent rise achieved by the S&P 500 this year, so what will hedge fund managers – who are supposed to be the smartest, savviest market players on the Street – do to juice returns?

For now at least, they’re not levering up in the hunt for yield. Certainly, they’re not ratcheting up portfolios to the levels seen pre-Lehman implosion, when returns were bountiful, and hedge fund managers reported leverage of 3.4, on average.

While funds are indeed sniffing around for and  investing in more highly-levered products like CDOs and CLOs – as we reported in a recent story on managers eyeing riskier exotic assets - prime brokers and traders say the demand for leverage in the form of borrowed cash from Wall Street lenders has not been high, despite the fact investors are starved for yield.

Data from Citi Prime Finance shows that gross leverage* across all strategies for hedge funds on its Prime Brokerage platform was at 1.74 at the end of August, up slightly from 1.73 in July, after falling for several months from a peak of 1.99 in February.  Overall leverage levels have remained pretty stable, according to the Citi data, between January 2011 and August 2012 – never falling below 1.67 and never going higher than 1.99. Over that 20 month period, the funds on Citi’s platform have averaged leverage of 1.8.

Hedge funds, particularly those in credit, were able to juice up returns before the crisis using, in addition to derivatives, leverage in the form of margin or borrowed money from Wall Street. Lenders were reluctant to extend that cash to hedge funds in the wake of the financial crisis, but now the tables have turned, portfolio managers said.

“Each of my three prime brokers is more than happy to provide new financing… asking me when we’re going to do some borrowing,” said a credit portfolio manager at a roughly $3 billion investment firm, who was not authorized to speak on its behalf.  ”From a credit standpoint it’s there and it’s available.”

“A lot of managers got smashed in 2007 and 2008 because of leverage,” the manager added. He, like several other credit managers that spoke to Reuters, is not planning to use more borrowed cash in the near-term to boost gains. “They learned their lesson and they aren’t indulging in borrowing yet to generate returns.”

And a report published Friday by BarclayHedge and TrimTabs says they don’t plan to do it any time soon, either. The report said hedge fund managers “are strongly inclined to maintain current levels of leverage,” and “plans to lever up fell slightly in September while plans to reduce leverage climbed by a small margin.”

Plans to keep leverage the same came in at 70.4% in September, down from 72.6% in August. Plans to lever up fell to 18.5% in September from 19.4% in August, while plans to reduce leverage climbed to 11.1% in September from 8.1% in August.

Reflecting hedge fund managers’ caution on leverage, margin debt has not changed much over the past several months… Total margin debt stood at $286.6 billion at the end of August, up 3.2% from July but down 10.6% from the recent high set in April 2011.

BlueMountain Capital Management co-founder Stephen Siderow told Reuters his firm, which oversees $10 billion in hedge fund and CLO assets, would prefer to take risk in the form of more complex, illiquid investments, rather than through leverage.

“Which risk is worth taking?” he asked. “We think illiquidity risk and complexity risk is relatively cheap. We don’t think leverage risk or concentration risk is cheap.  We’d rather  be diversified and unlevered. Like many others, we are avoiding and don’t want short-term unstable leverage provided by Wall Street.”

Of course, it is much more difficult to measure the exposure hedge funds have to so-called ‘embedded’ or ‘hidden’ leverage, which they can get by investing in products like CLOs and ABS, or in derivatives,  which are more highly levered in themselves.

* Gross Market Value Leverage defined as:  ( Long Market Value +  Absolute Value of Short Market Value) / Net Equity)

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