When Leverage is Evil
“Risk is good. Not properly managing your risk is a dangerous leap.”
— Evel Knievel
Leverage per se is not evil. We only get a problem when an invester goes overboard…as hedge funds typically tend to. When the secretive Citadel Investment Group—a multi-billion dollar hedge fund—filed disclosure documentation in 2006 (preparatory to issuing bonds), they revealed that of $5.5B in expenses during 2005, 90% went for interest payments. How do you rack up $5B in interest expenses in one year? By borrowing mucho dinero.
What is leverage, again?
Let’s review the bidding. If you have $1000 and buy 100 shares of XYZ stock worth $10 a share, and a week later XYZ has gone up to $11, then you made $100 or a 10% ROI, and life is good. However, if you took that same $1000 and bought 200 shares of XYZ on 50% margin—i.e., your broker loans you the money to buy the second 100 shares—then we consider that you have 2x leverage, as the value of the equity you control is twice the total of your funds invested. Now if XYZ goes up to $11, you have made $200 on your $1000, or a 20% ROI (minus the small amount of interest you owe your broker for loaning you $1000 for a week). Life is very good.
There are other ways you can leverage your money. For example, you could buy XYZ call options instead of buying the stock. A call option gives you the right to buy 100 shares of a stock at a specific price from now until a certain date. The prices for call options vary depending on when they expire, how far away from the price at which you can exercise the call option the underlying security's price is, how volatile the price of the underlying security is, and other factors. For the sake of argument, let's say you buy $10 call options for XYZ that expire in three months, and they cost you $1/share, or $100/option (remember each option gives you the right to buy 100 shares of XYZ at $10/share). You can afford 10 options, which means you now potentially control 1,000 shares of XYZ, instead of only 100 or 200. If the price of XYZ rises $1 to $11 in one week, your options are probably going to be worth $2 or so per share. Sell your options and you have a profit of $1000…let’s say, a 90% ROI after taking commissions into account…and life is sublime!
When good leverage goes bad
OK, back to Citadel. According to their disclosures, they commonly carry as much debt as $100B and control assets worth up to $166B…which given assets under management of $13B translates into leverage of 12.8x. That is, for every dollar invested with Citadel, management contrives to control $12.80 of assets using a combination of purchases on margin, short sales, options, and derivatives. When things go well—which is more often that not given that hedge fund managers know what they are doing—the fund collects outsized profits (12.8x more than they would have investing their dollars unleveraged, minus their interest expenses). But it is a game of Russian Roulette, and when things go wrong, you can get a fatal $6.6B spanking really fast, as did Amaranth Partners in 2006.
But it gets worse. In the last few years, financial professionals have invented and heavily marketed new investment vehicles that package leveraged risk: chief among these being the credit default swap (“CDS”). A CDS is a contract in which the buyer makes a series of payments to the seller in exchange for the promise of a specified payoff in the event that a credit instrument (typically a bond or loan) goes into default, or upon the occurrence of a specified credit event (for example bankruptcy or restructuring) within a specified time frame. Investment bankers at J. P. Morgan invented the CDS in 1997; in the ensuing 11 years the value of CDSs extant has risen from nothing to trillions—estimates as of the end of 2008 vary from $12 trillion to $45 trillion. This uncertainty can exist because there is no centralised exchange or clearing house for CDS transactions; these are all done over the counter…nor is the market regulated. And the uncertainty is not only quantitative, but qualitative…in her illuminating article on the invention of CDSs, Financial Times capital markets editer Gillian Tett writes:
…[T]he whole credit derivatives world has exploded at such a dizzy pace that nobody is exactly sure where the loan risk has gone. Have all the investors who have bought credit derivatives contracts checked the fine print to see what losses they could sustain? Does anybody understand the chain reaction that might be triggered by such losses? Could the world's trading systems cope? And what would happen to all those hedge funds that have been jumping into the credit derivatives world?What we do know, is that it is not just hedge funds who are into potentially evil leverage. While initially the concept behind the CDS was to insure the owner of particular securities—viz., J. P. Morgan—against the risk of default, as the popularity of the instrument expanded, speculators began to sell and trade them and demand exploded. In his brilliant February 2007 prediction of the imminent credit crash, Satyajit Das explained how this dynamic worked:
The CDS only allows banks to push credit around amongst each other. A bank with too much risk to a firm buys protection. A bank with too little exposure is happy to sell protection. It is the “push and pull” of credit markets. To go beyond the push and pull, banks need to shift risk to “real money”—investors. Investors traditionally have been content to lose money investing in government bonds, shares and property. They had to be convinced about a new “asset class”. Bankers trooped to investors and their masters, the asset consultants. They wailed a new siren song—“credit is a new investment asset”. There was “diversification”. Credit did not move together with other asset classes. There was “return”. Credit risk gave you a higher return than government bonds. There was “volatility”. Risk margins fluctuated. Excited investors immediately assumed that with their superior skills they would make money. They didn’t seem troubled at all that the volatility may translate into losses not profits.
Until his recantation on 23 October 2008, former Federal Reserve Chairman Alan Greenspan was a big fan of CDSs, the theory being that they would spread the risk and thus lead to stability. Unfortunately, the newfound ability of risk originators to offload their risk—and depend upon transaction fees and bonuses to make their money—created incentives for them to create and sell more and more risk, with less regard for the quality. The result: financial WMDs…lots of ’em. It turns out that the combination of a huge valuation bubble (in real estate) and new, powerful, poorly understood financial instruments that enabled the resultant bad risks to be aggressively distributed…indeed, actually increased the demand for the bad risk!…is an extremely efficient mechanism for doing damage to the economy.
Risk management at Intelledgement
In our view, optimal risk management consists of a set of general policies melded with the risk tolerance of each client…which we ascertain by dint of a survey upon signing a contract and update annually. In general, we eschew the use of leverage aside from targeted short sales. We will sell covered calls on near-fully valued equities and we do buy puts to hedge large gains and to limit losses; otherwise, we generally avoid option plays. (Options are only available for the most heavily traded EFTs.) Positions are reviewed regularly, and irregularly as triggered by the attainment of designated price targets (both losses and gains).
Generally, buy and sell decisions are tied to fundamental macro strategy analysis. For example, if we anticipate that the Fed is likely to lower interest rates to stimulate the economy, then we are likely to be long U.S. bonds, housing, and financial services ETFs. Conversely, if we anticipate the Fed will raise interest rates to defend the value of the dollar, then we would likely be short those ETFs (or long reverse ETFs that increase in value when whatever they are tracking declines).
We don’t mean to be critical of the more aggressive risks undertaken by hedge funds…clearly the record indicates that such risks payoff overall, for the majority of investors. However, we do believe that applied judiciously, a more measured application of macro analysis strategy can produce comparable market-beating returns while virtually eliminating the risk of an Amaranth-class disaster.