The Role of Leverage

Although leverage increases the volatility of returns, it is not a strategy risk factor per se. Gross leverage is defined as the sum of long asset market value and short asset market value divided by equity. In contrast, net leverage is defined as long asset market value less short asset market value divided by equity. The latter is a good measure of leverage when long and short positions are used to hedge each other. When long and short positions expose a fund to the same primary risk factors in similar ways, then the former more accurately reflects leverage.

In any case, balance sheet leverage (which is generated from borrowing, as described in the previous paragraph) is distinct from instrument leverage. Together they determine the risk profile of a hedge fund. Also known as economic leverage, instrument leverage is derived from the riskiness of the hedge fund's assets and the fund's net position in them. For example, futures, options, and swaps typically have high instrument leverage because they allow investors to gain large amounts of price exposure with a relatively small investment. Even though relative value hedge funds use these instruments extensively, their long-short positions negate most of the instrument leverage.

Because relative value hedge funds typically have low instrument leverage, they have the ability to absorb high balance sheet leverage and typically do. In contrast, event driven strategies tend to have little balance sheet leverage but use instruments, such as distressed securities, with high economic leverage. Hedge fund strategies will generally trade off between the two. However, recall that LTCM was exposed to both high balance sheet leverage and high economic leverage (despite its many iong-shorr positions), which helped define its risk profile and contribute to its demise.

Ir is important to note that balance sheet leverage also magnifies liquidity risk. By allowing a fund to purchase more assets than it has equity, leverage enables a hedge fund to assume positions that are too large to liquidate quickly without significantly affecting market prices. As the Metallgesellschaft and LTCM cases illustrate, balance sheet leverage can force a hedge fund to liquidate positions if mark-to-market losses and. margin calls consume a fund's equity. If the market is not sufficiently liquid to absorb the size of the fund's trades, the resulting market impact may generate yet more margin calls in a self-perpetuating cycle.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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