Leverage

Virginia Reynolds Parker, CFA
President
Parker Global Strategies

Leverage definitely makes the top ten list of misapplied concepts in the hedge fund world. Discomfort with the leverage of a portfolio reflects a concern for portfolio volatility risk and, for those strategies depending heavily on leverage to generate returns, a concern about financing availability.

Unfortunately, the most common leverage measurements derive from balance sheet leverage concepts. Corporate leverage calculations have value as a relative measure between companies in the same industry sector, although as a standalone measure they provide little meaningful information about the financial risk of a specific company. The corporate world focuses more on cash flow, and considers EBITDA (earnings before interest, taxes, depreciation and amortizations) ratios as more indicative of financial risk. In the hedge fund world the most common measures of leverage are gross leverage and net leverage. Gross leverage is: (longs + absolute value of shorts) / portfolio equity. Net leverage is: (longs + shorts) / portfolio equity. While these ratios have value as relative measures between hedge funds trading the same strategies, as standalone measures they provide little insight. Other tools must be used to analyze the true risk of leverage in a hedge fund --- the volatility and financing risks.

Measuring Volatility Risk Where Systematic Risk is High
In a previous "Ask the Expert" column on VaR (Value at Risk) we alluded to the issue of hedge fund leverage. Let me quickly refresh your memory about VaR and then return to the subject of leverage. VaR is a methodology used to measure the systematic risk in a portfolio of assets, the risk that cannot be diversified away. VaR represents a quantitative method to compare risks across asset classes, the basis of which is an analysis of historical volatility of assets.

The concepts of VaR and leverage overlap in their common concern for portfolio volatility risk. Several methods exist for assessing the level of volatility risk in a portfolio, depending on the strategy. For strategies with little non-systematic risk, i.e. those well suited for VaR analysis, the units of VaR divided by the portfolio equity provide an excellent measure of volatility risk in a portfolio. For these strategies, VaR is superior to other leverage measures. For example, consider two accounts with $1 million of portfolio equity each, where Portfolio A has $500,000 of 30-year U.S. Treasuries and Portfolio B has $3 million of US Treasuries bills that mature in one week. Using the standard definition of hedge fund leverage, Portfolio A has only 0.5% leverage, while Portfolio B has 300% leverage. Yet, Portfolio A has much more capital at risk than Portfolio B. This is because Treasury bills maturing in one week have a very short duration, or low volatility, compared to the 30-year Treasury bond.

The most appropriate measure of risk for this type of portfolio is VaR. Good examples of where VaR appropriately measures leverage include fixed income arbitrage strategies, particularly as related to higher quality bonds, and CTA strategies (a.k.a. managed futures). In the latter case, we might consider an additional leverage proxy such as margin to equity usage, taking into consideration span margin which reflects the exchange’s evaluation of historical volatility.

So what does a leverage ratio based on VaR/portfolio equity really tell us about a fixed income arbitrage strategy that includes little non-systematic risk? Let me refresh your memory again: VaR is not a good measure of two things 1) non-systematic risk and 2) tail risk. Therefore, this leverage ratio gives us a very good measure of what percentage of portfolio equity is at risk in normal markets, because in this instance the portfolio has little non-systematic risk, but it tells us less about the portfolio equity at risk under extreme or catastrophic circumstances. What happens, for instance, when Russia defaults on its debt, and yield curves and bond spreads suffer extreme volatility? What happens when asset liquidity dries up and when financing availability dissipates? Stress testing and scenario analysis provide additional insight into the potential downside risk to this portfolio.

Examples for Measuring Volatility Risk Where Non-Systematic Risk is Relatively High
For long/short equity managers, where VaR is less useful because of the relatively high non-systematic risk of equities, gross and net leverage calculations are just a starting point. For example, two portfolios have portfolio equity of $1 million --- Portfolio A comprises a long portfolio of $2 million and no short portfolio; Portfolio B comprises a portfolio of $1.5 million long and $1.5 million short. The first portfolio has gross leverage of 2 times while the second portfolio has gross leverage of 3 times. Yet, under most market circumstances, Portfolio A is considerably more risky that Portfolio B. By also looking the net leverage, we would measure leverage at 2 times for Portfolio A and at 0 for Portfolio B. To further peel the onion, we recommend slicing and dicing the data to look at these leverage measures by industry sector and by country. This sheds light on concentrations of risk and provides direction for the purposes of stress testing and scenario analysis.

For merger arbitrage, we recommend measuring leverage in a similar way as for long/short equity portfolios, examining both gross and net leverage. We also look at the "paired positions" for merger arbitrage to ensure that there is a spread capture being targeted as opposed to a directional bet that the deal will or will not go through. We consider what would happen if a number of paired positions go against the manager at the same time.

For fixed income strategies related to less quality credits, we look at VaR, duration and the volatility of the credit spread against treasuries. Again, stress testing and scenario analysis are the ultimate tools to understand downside risk.

We look at gross leverage for emerging market debt, because managers should be able to capture sufficient return without using leverage. If a manager needs to use leverage in an emerging market debt portfolio to generate sufficient returns, then it is likely that spreads are too narrow to the US and that emerging market debt may not be attractive.

A Quick Note on Financing Risk
In our last "Ask the Expert" column we talked about financing risk in relation to many market neutral strategies. We discussed the more leveraged strategies such as fixed income and mortgage arbitrage. To summarize our key point on financing risk --- the more leveraged strategies are most vulnerable when prime brokers and other financing sources pull lines to protect themselves against losses during economic crises. Therefore, we always recommend that investors study the liquidity characteristics of a strategy, the size of the manager which may impact his flexibility in shifting towards a more liquid portfolio during rough periods, and the obligations of financing sources for each manager.

Summary
Leverage calculations provide limited value in the analysis of the true risk of a hedge fund. Ultimately, managers and investors need to drill down to the imperfect art of volatility and financing risk analysis to make informed judgments about manager and portfolio risk.

Parker Global Strategies, LLC

Parker Global Strategies is a Manager-of-Managers providing a broad spectrum of Alternative Investment Strategies to private and institutional investors.