Lessons Learned from Leverage

Via ZeroHedge: Howard Marks of Oaktree wrote another memo in March, addressed only to clients and their consultants, in which he detailed his funds' failures at using leverage in 2008. The money quotes for me:

• There's a big difference between value investing and absolute-return investing, and we've learned it fully. A fund that's truly capable of consistently producing positive results may be well-suited to leverage. On the other hand, even though value investing represents the best way to achieve excellent results in the long term, it's still subject to large enough short-term fluctuations that the use of leverage has to be examined critically. It's interesting to note that the Emerging Markets Fund, Oaktree's only absolute return fund, achieved positive returns in 2008 even though it relies on leverage to let it hold long and short positions exceeding 100% of its equity capital.

• Finally, once you decide to lever a fund, "risk management" becomes more important than "portfolio management." Many more people know how to pick securities than know how to restrict a levered fund's risk to the amount that can be withstood. And the ability to pick securities for an unlevered fund isn't nearly as critical as the ability to manage risk in a levered fund.

End of excerpt

The first statement--"There's a big difference between value investing and absolute return investing"--is one you seldom see emphasized in hedge fund marketing documents. There is, it seems to me, almost a Montague vs. Capulet-level divide between the goals of value investing and those of absolute return investing. If one's goal is the best results in the long term, Marks argues that value investing is your best bet. But the price to be paid for this goal is the willing acceptance of short-term performance fluctuations, fluctuations that almost always render impossible the long-term use of leverage. If one's goal on the other hand is absolute returns--consistently positive results--then leverage is more appropriate but it forces you to eliminate from the universe of things you look at the value investing opportunities that produce the best long-term results.

My sense is that many long-short hedge fund managers who call themselves value investors try too hard to walk this tightrope: they seek the blessings that come from being known as a value investor while also promising the consistently positive results they feel institutional investors require.

Comments

[Tom Armistead:]

The observation that value investing and the use of leverage may be incompatible would also apply to individual investors.

Howard Marks did a very good job discussing the issues - he deserves a lot of credit for his frankness and honesty in explaining what went wrong.

The use of leverage may make more sense when the expected returns of the investments are high. For example, at the market lows on 3/10 or thereabouts, the return based on the assumption that the market would soon revert to a less distressed level was much larger than the interest rate charged by brokers for margin accounts.

Apr 05 12:23 PM

[Hedge Fund ...:]

Great set of thoughts. Agree wholeheartedly!

Apr 05 02:57 PM

[Mad Hedge F...:]

The scenary is going to change! After last year’s carnage, you can expect the remnants of the hedge fund industry to split in two. One group will inherit large, illiquid fixed income positions, like convertible bonds and subprime CDO’s, and evolve into private equity funds, which they should have been all along. The rest will retreat to trading large liquid global positions that did well during the nineties, offering investors quarterly redemptions they now demand. Fees will fall across the board. This is how hedge funds will cope with a new world that is transitioning from excess capital to a capital shortage.

Apr 05 06:08 PM

[William Cowie:]

Very good observation.

The notion that long term value investments should have limited leverage has long been trumpeted by none other than the master of value investing, Mr. Buffett. To my stupid ears, the words hedge fund and value investment don't sound like they belong in the same sentence (which I notice I just did).

Apr 05 06:33 PM

[Allan Frain:]

Leverage and volatility are incompatible. Volatility will dominate for some time and leverage has damaged its reputation.

Apr 06 10:12 AM