Risks Unique to Hedge Funds
Leverage—A Source of Undue Risk or A Way to Increase Alpha?
Some view leverage as one of the main reasons why hedge funds are so risky, while others believe that properly managed leverage can yield excess returns.
Hedge funds use leverage as a regular part of their trading strategies. In certain cases, such as arbitrage, leverage is the key “ingredient” simply because without it, arbitrage profits would be too small to justify either the cost or the effort. In other words, leverage works as a “profit amplifier” of sorts.
However, investors should understand that just as leverage amplifies profits, it also amplifies losses. This is why leveraged investment vehicles are generally considered more aggressive and of higher risk than most.
The leverage ratio in hedge funds today can range from 2:1 to 10:1, depending on what types of assets are held in a hedge fund and what trading strategies are used by the fund’s manager. And then there is the story of Long Term Capital Management hedge fund, which at one point had the leverage ratio of 500:1. No wonder that with such leverage “power” the fund posted annualized returns of more than 40% in the mid to late 1990s. But when the fund lost an amazing $4.6 billion within a quarter, it became clear just how risky the use of leverage can be. (Source: Lhabitant F.S., 2002)
How Leverage Is Created
Hedge fund managers create leverage by employing the following trading strategies:
- outright borrowing of funds;
- short selling;
- trading in traditional margin accounts; and
- trading derivative instruments typically requiring only a fraction of the actual value of the assumed position.
Other Hedge Funds Risks
While leverage seeps through to many levels of market and trading risks, hedge funds must also take into account other types of risks that are unique to them. One such instance is the liquidity risk, which refers to sudden and unexpected appearance of a thinly traded market. For example, one of the reasons why Long Term Capital Management hedge fund folded so spectacularly in 2000 was the absence of a normally liquid market.
There is also the pricing risk, which appears when hedge funds trade in over-the-counter (OTC) markets. Stocks in such markets are often traded infrequently, particularly when there is much volatility. This is why brokers and dealers have very conservative approach to such stocks and apply mark-to-market of outstanding positions, which can create often a severe cash needs for hedge funds just to maintain their margin requirements. Note that the pricing risk amplifies the liquidity risk.
There is also the counterparty credit risk, which is the risk of the other side in a transaction having difficulty or being unable to meet its delivery or receipt requirements. In other words, this is the possibility of a counterparty to default on its payments (regardless whether the payment is to be made in cash or in-kind). The counterparty credit risk is very closely tied to the settlement risk, which is the possibility of the other party not being able to settle the transaction in full within the legally provided time frame.
Since hedge funds often employ short selling strategies, they are also exposed to the short squeeze risk. This type of risk arises when the market forces hedge fund managers to cover their short positions at unfavorable prices.
Finally, there is the risk of financing squeeze. Namely, if a hedge fund is overleveraged, it means that the fund’s ability to borrow more funds is extremely limited. However, there is no way of telling when margin and mark-to-market requirements can put undue strain on the hedge fund’s need for cash. If and when something like this happens, hedge fund managers are often forced to unwind some of their existing leveraged positions, which, if acquired in illiquid markets, can adversely impact the fund’s performance.
Source: International Investments, Fifth Edition, by Bruno Solnik and Dennis McLeavey, 2004.)
