Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Friday, October 06, 2006

Hedge Funds and Leverage

Felix Salmon on Floyd Norris of the New York Times:

Does leverage always magnify a hedge fund's returns?:

Floyd Norris yesterday:<

Even with the wonders of leverage, outperforming the stock market by enough to overcome the typical hedge fund manager’s compensation of 2 percent of assests and 20 percent of profits ought to be very difficult. As a group, it is very unlikely that a large group of hedge funds could do so on a prolonged basis. (Emphasis added.)

Norris makes a good point. I always thought that so long as the stock market was going up, outperforming it was childs play precisely because of the wonders of leverage. You just buy twice or three times as many S&P 500 contracts as you have assets under management, and watch the profits roll in. (Not that any hedge fund manager would actually do that, of course.)

But the thing about prime brokerage operations - the windows where hedge funds get their leverage - is that they lend money at, the prime rate, or slightly below it. With prime over 8% right now, the stock market doesnt just need to be rising, it needs to be rising at more than an 8% pace in order for the leverage to pay.

Of course, if you play in stock-market options you can make money even with a lower rate of return than that: you just write puts to your hearts content and keep the proceeds as the stock market rises inexorably. But that doesnt really need leverage at all. Norris's point is well taken: with the amount of money pouring into hedge funds wiping out most arbitrage opportunities, weak results out of the sector are going to be increasingly common.

First, when somebody buys puts, they are implicitly selling the stock market short--planning on profiting when the stock market goes down. When you sell puts, you are implicitly going long the stock--you are planning on losing money if the stock market goes down. You are leveraged. You are leveraged in an amount that is hard to calculate (especially if you don't believe that asset values are geometric Brownian motions), and in a degree that your (or your clients') unsophisticated accounting and risk-tracking systems may not register. But you are leveraged.

Second, I had always thought that hedge funds existed to deliver (a) better than bond returns with (b) bond-level short-run risks. (The risks of long-run investments in bond are, of course, enormous because of the potential for inflation.) Hedge funds are supposed to have a beta as close to zero as possible, so that clients can decide how much systematic stock-market risk they want to run independent of their investments in hedge funds.

Of course, tnobody knows what their current alpha and beta really are. And with trillions of dollars of money now chasing a much smaller amount of harvestable alpha--well, a lot of "successful" hedge funds over the next two years will be "successful" by making lucky high-beta bets where they can disguise the real systematic risks they are running from investors...


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