Given repeated headlines of late about the role of leverage, it may be surprising to learn that there is no universal metric that captures the likely economic impact of its use. Ask ten asset managers how they measure the use of other people's money and you are likely to get ten different answers.
This is a big deal since investment leverage is a key driver of performance which in turn relates to fees paid by institutional investors. While leverage can be a boon to return-hungry pensions, endowments and foundations, misused or miscalculated, leverage can result in massive and unanticipated losses. Prudent investors need to ask managers if their funds are levered, to what extent they are levered, what strategies were used to lever the portfolio and whether stop loss mechanisms have been put in place to contain things, as market conditions sour.
According to "Overview of Leverage," published by AIMA Canada, one calculation (referred to as Net Market Exposure or Net Leverage) takes the dollar difference between long and short positions and divides by a hedge fund's capital base and then multiplies the ratio by 100%. However, as Virginia Reynolds Parker, CFA rightly points out, balance sheet inputs can limit the usefulness of leverage ratios, especially if there is a big disconnect between where an instrument is likely to trade versus its stated value for financial statement reporting purposes. (It is too soon to know whether FAS 157 compliance will close any economic-accounting gap and therefore render point in time ratios more effective as a risk gauge.)
While not all funds employ leverage, it is not uncommon for a portfolio manager to employ derivatives, margin and/or outright borrowing in order to effect a disproportionate exposure to a particular asset or liability class. Leverage can vary by strategy as documented in "The L Word" (Investment Review, Spring 2008).
As author Peter Klein shows, hedge fund strategies such as convertible arbitrage employ higher leverage levels than a "less risky" market neutral strategy. However, he warns readers to take care in relying on leverage ratios alone, adding that correlations and overall riskiness of portfolios must also be considered. This blogger agrees with the notion of looking at multiple metrics but encourages investors to go way beyond numbers and look at the asset manager's process with respect to all things leverage.
Hedge funds are not the only entities to employ leverage. Wikipedia reports that leverage, measured as total debt divided by stockholders' equity, for five major investment banks (Lehman Brothers (OTC:LEHMQ), Bear Stearns (BSC), Merrill Lynch (MER), Goldman Sachs (GS), Morgan Stanley (MS)) steadily rose between 2003 and 2007 to more than 25. Click here to access the source data to verify for yourself. Institutions are well familiar with 130/30 funds and variations thereof. Mutual funds use leverage as do exchange-traded funds ("ETFs'). In "Read the Fine Print on Leveraged Funds," Wall Street Journal reporter Tom Lauricella warns about the new math that can roil investment value quickly, adding that these vehicles are not for everyone.
Investors need to decide for themselves after (hopefully) doing the requisite homework about how leverage is being managed, if at all.