Estimates of Hedge fund leverage

As mentioned earlier, after the collapse of LTCM, whose leverage at the time of collapse was estimated to be 25 to 1 and even more, hedge fund leverage attracted more regulatory and academic attention. According to the Hennessee Group’s research in 2003, 84% of hedge funds in its sample use less than Regulation T level of leverage which puts the margin requirement at 50% level. Namely, the effective leverage of the sample of hedge funds in their data was 2:1.

According to their study, only 2% of hedge funds (mostly convertible arbitrage funds) use leverage in excess of 500% (5:1).⁸⁷

As of March 2003, Gupta and Liang find that the majority of hedge funds in their sample of 1,500 hedge funds do not employ excessive leverage.⁸⁸ The rate of high level of leverage in live hedge funds was 3.7% of all live funds in their sample. Furthermore, according to their findings, the undercapitalized live funds tend to be very small funds constituting 1.2% of the total fund assets in their sample. As for extinct funds, they found that 11% of hedge funds from among the total dead funds were undercapitalized. This finding is consistent with the theory asserting that one of the reasons of the failure of hedge funds is undercapitalization.⁸⁹

A survey by Bank of England also suggests that nearly 20% of hedge funds used no leverage at all in late 2004, and 50% of hedge funds used leverage of less than one times their equity.⁹⁰ According to Van Hedge Fund Advisors report in August 2005, approximately 20% of hedge funds employed no leverage at all. And about 50% employed leverage of less than 1 to 1

86 Daníelsson, Taylor and Zigrand, Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, pp. 529-530.

87 Hennessee Group, Comments of Hennessee Group LLC—for the U.S. Securities and Exchange Commission Roundtable on Hedge Funds, 2003), p. 12.

88 They use a Value-at-Risk-(estimated through Extreme Value Theory) based capital adequacy measures to evaluate whether hedge funds have enough capital or not.

89 Gupta and Liang, Do Hedge Funds have enough Capital? A Value-at-Risk Approach, 219-253.

90See King and Maier, Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks, pp. 294-295.

including the leverage created by short positions.⁹¹ Other studies show a decline in the level of leverage employed by hedge funds in 2007-2008.⁹²

To understand the significance of the level of leverage of hedge funds it should be contrasted to the level of leverage of the mainstream financial institutions. Comparing hedge funds’ leverage with that of other financial institutions will show that the hedge fund leverage is just a small fraction of the leverage of the regulated financial institutions. As an example, capital adequacy requirements (CARs) for banks are set at 8%. With this level of CAR, regulated bank’s leverage ratio can be 12.5:1.⁹³ Therefore, even after the implementation of the Basel III capital requirements, the level of leverage allowed for banks will be much higher than the de facto leverage of hedge funds.⁹⁴

Ang, Gorovyy and van Inwegen’s empirical analysis of hedge fund leverage from December 2004 to October 2009, show that the hedge fund leverage, compared to that of investment banks and broker-dealers, is ‘fairly modest’. A more interesting finding is that the leverage of hedge funds is counter-cyclical to the market leverage of listed financial intermediaries. Ang, Gorovyy and van Inwegen also show that prior to the financial crisis in the mid-2007, while the leverage of regulated investment banks continually increased, hedge fund leverage decreased. In the worst period of the global financial crisis in which the investment banks’ leverage was at its peak, hedge funds leverage was at its lowest point.⁹⁵

91 Banque de France, Financial Stability Review: Special Issue on Hedge Funds, 2007), p. 52.

92 King and Maier, Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks, pp. 294-295.

93 Daníelsson, Taylor and Zigrand, Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, 522-543.

94 See Admati and Hellwig, The Bankers' New Clothes: What's Wrong with Banking and what to do about It.

95 Ang, Gorovyy and van Inwegen, Hedge Fund Leverage, p. 121.

According to this study, gross leverage for hedge funds until mid-2007 was approximately 2.3, where it started to decrease from 2.6 in June 2007 to a minimum of 1.4 in March 2009. At the end of the period – October 2009 – the authors estimate the gross leverage across hedge funds to be 1.5. And over the whole period, the average gross leverage was 2.1.⁹⁶ As the above figure clearly shows, hedge funds’ leverage is much lower than the leverage of banks and that of the financial sector in general.⁹⁷ Overall, it seems that the lower levels of leverage employed by hedge funds could partly be explained by the market discipline imposed by their counterparties, creditors, investors, and the internal governance mechanisms embedded in the hedge fund industry.⁹⁸ Namely, even if large hedge funds were willing to employ higher levels of leverage,

96Ibid. They also show that the leverage for the event-driven and equity funds is on average lower (1.3 and 1.6 respectively) than for all other hedge funds which have an average gross leverage of 2.1 over their sample. In the recent crisis, they also show that both the event-driven and equity sectors reach their highest peak of gross leverage in mid-2007 and gradually decrease their leverage over the crisis.

In addition, one of the proxies for measuring leverage is comparing the volatility of trading returns with the volatility of underlying assets in which hedge funds invest. According to this model, the higher the volatility of trading returns, the greater the risk of the investment. Studies suggest that for banks the ratio of this measure was 1.5 which peaked at 2.2 in the second quarter of 2000. However, this measure for average hedge funds was 0.7. See S.

Jones, "US Bank Leverage almost Double Hedge Funds," FT.Com, 2001.

97 Bianchi and Drew, Hedge Fund Regulation and Systemic Risk, 6-29. Even after the introduction of Basel III, the

level of leverage allowed for banks will be much higher than the de facto leverage of hedge funds.

98See Houman B. Shadab, "Hedge Fund Governance," Stanford Journal of Law, Business, & Finance 19, no. 1 (2013).

their prime brokers, investors or partners might not be happy with higher amounts of leverage and hence they put actual limits on the leverage of hedge funds.⁹⁹

Needless to say, the countercyclical leverage of hedge funds can prevent the crisis from getting worse. This is because when other financial institutions are forced to deleverage by selling their assets which in a distressed markets can contribute to fire sales and downward asset price spirals, the funds with countercyclical leverage can take the contrarian positions to form a floor below the price levels and prevent them from further collapse. Therefore, it seems that the role of hedge fund leverage in financial instability is exaggerated.¹⁰⁰ At least, for small and mid-sized hedge funds, the level of leverage is unlikely to be systemically important.¹⁰¹