Hedge funds should not be leveraged

My inner Roubini has been kicking the shit out of my inner Cramer for more than a year now. So it was with some surprise that I found myself nodding along and murmuring “Amen” to Cramer’s New York magazine piece on hedge funds, After Amaranth.

Cramer makes some pretty obvious, good points. Like, since hedge funds are supposed to be for highly risk-tolerant investors, pension funds oughtn’t be in the game.

(I know, I know. Asset allocation, low covariance, diversification benefits, yadda yadda yadda. With perfectly disciplined, reasonably informed investment managers, pension funds ought to be able to achieve more optimal portfolios with some exposure to this alternative investment class. But, star pension fund managers will always be more competitive than discipled, and hedge funds are too secretive for pension managers to adequately evaluate. Risk-taking by pension funds is particularly unethical since risk-intolerant pensioners are much more exposed to the downside than the upside of pension returns. See agency cost #4.)

Regarding pensions, Cramer offered the following suggestion:

The other way to regulate hedge funds is to say that you can’t borrow more than, say, 50 percent of the money you have under management to leverage up, if you are running pension money.

This got me thinking. Why should hedge fund be leveraged at all?

“What?!? Hedge funds are all about leveraged investment strategies!” I know, I know. But hear me out. Hedge funds are for rich people, with lots of capital and risk tolerance, right? So why shouldn’t hedge fund investors — people with sophisticated access to capital and credit markets — lever themselves, investing in unlevered funds with their own borrowed money? Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same. And while investors may enjoy letting their bankers share much of the downside of their investments, there’s little reason to think this is good for the rest of us. It hardly seems fair for the public to bear systemic risk in order to enhance the private returns of the wealthy. If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed), and better diversified (as the cost of a big fund meltdown would be spread among the many banks who lent to various investors, rather than concentrated in the one bank that lent to the fund). Also, investors could better tailor their hedge-fund investments to their own level of risk tolerance.

Finally, without leverage, hedge funds would have to compete based on the intelligence of their investments, rather than their ability cajole bankers into lending them too much money, too cheaply. In such a world, it might actually be true that these funds would fuction to squeeze inefficiencies out of markets, rather than highlight and take advantage of conflicts of interest between bank managers, depositors, and governments..

I’m not suggesting that hedge funds shouldn’t be able to borrow at all, as many hedge-fund strategies, like going short, require borrowing. And the implicit leverage inherent in many derivatives positions would represent a challenge to any regime that purported to regulate hedge fund leverage without otherwise limiting investment cleverness. Nevertheless, at least in theory, is there any good reason why limited liability investment funds for the rich and creditworthy should be permitted to take on high degree of leverage?

Update History:
  • 1-Nov-2006, 6:00 a.m. EET: Removed an unnecessary word. (“…pension managers to adequately evaluate them.”)

One Response to “Hedge funds should not be leveraged”

  1. Aaron Krowne writes:

    Of course, I agree.

    The situation is made even worse by the implicit assumption that hedge funds have themselves become the least-cost bearers of risk — as evidenced by the reduction of bank reserves in favor of cash flows directly connected to hedge funds (as well as the de-emphasis of other bank cash flows — i.e. traditional lending and consumer credit).

    Then, they are not simply adding to the pressure upon the financial fabric’s least cost bears of risk, but they are in fact displacing them in favor of nothing. The potential here is for us to wake up one day and find widespread insolvency and the evaporation of vast quantites of virtual wealth, rather than just a bunch of major banks with poor quarterly profits.