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Todd Stein & Steven McIntyre (The Texas Hedge Report) submit: In general, hedge funds are not good investments. Combine the steep fees with the fact that the overwhelming majority of fund managers underperform the market, and the odds are stacked against the investor right from the start. Unless you think you’ve found the next Warren Buffett, you would most likely be better off investing on your own through index or exchange traded funds.

Fund managers know they need to post superior returns in order to justify their fees as The New York Times and The Wall Street Journal have spilled plenty of ink recently detailing the high fees resulting in several freshly minted hedge fund billionaires over the last year. A recent Times article quoted an investment advisor saying that he didn’t mind paying the high fees as long as the performance was there. That seems fair enough, but it reminds us of an environment where baseball players were encouraged to use steroids and other drugs in order to break home run records. Evidence has come out that owners, coaches, players and reporters knew what was going on, but mouths were kept shut for the good of the game in terms of television ratings. On Wall Street, the steroid known as leverage is 100% legal and its use is encouraged by investment banks and institutional investors all over the world.

Let’s consider a hedge fund that is invested in a handful of widely-held large cap stocks. Many components of the Standard & Poor’s 500 are levered several times their annual operating earnings, so let’s say a fund manager’s stocks have an average of 3x leverage at the corporate level. Then let’s assume that the manager applies 3x leverage at the portfolio level. This actually seems conservative given that we have read about several large funds using double-digit leverage ratios in recent years. Next, let’s assume that a handful of large funds-of-funds (levered at 2x) comprise the investor base of the fund. Since funds-of-funds often charge their own layer of fees, they are encouraged to lever as well. Finally, the individual people that invest in funds-of-funds often lever up themselves. We will assume an individual levers at 2x.

TH 1

So when you do the multiplication math above, the leverage ratio of investor capital to assets from top to bottom is an astonishing 36-to-1. This means all you need is a 3% average drop in portfolio earnings and corresponding drop in portfolio value and some select end investors could be wiped out in the daisy chain of leverage as seen below.

TH2

To be fair, most hedge funds short a significant amount of stock, and these positions would benefit from a market-wide decline in earnings. However, given the strong stock market of recent years and days (the Dow is now up 23 of the last 25 trading days), we think the temptation has clearly been to lessen money-losing shorts to chase after ever-increasing longs. When the tide goes out, we may find out that a lot of fund managers were swimming naked. In such a scenario, it wouldn’t take a tremendous downdraft to wreak a lot of havoc given the record breaking amounts of leverage in the system.

The question may arise as to why we didn’t see stories in the newspaper of funds or notable individuals having problems when the Dow got hit for just under 4% in a single day in February. The answer is that the short term drops of several percent can largely be papered over in the short run by extensions of further credit at brokerage houses and banks. Heck, we would argue that many brokers and banks that have lent money have no clue as to the true value of the collateral that is posted throughout the chain. Given that a wide range of synthetic instruments, derivatives, and less liquid asset classes are often “marked to model”, it may take a number of months for the head-in-the-sand lenders to realize their collateral is worth a lot less than a hedge fund’s model. We venture to guess that a sustained 10-15% drop in corporate profits along with a corresponding drop in most stocks could set off a leverage liquidation chain.

It’s one thing to be willing to pay hefty hedge fund fees for outstanding stock/asset picking performance. It’s another thing to pay hedge fund fees for mediocre performance juiced by leverage. We think a perfect storm is brewing that may put a downward pressure on the vast majority of asset classes simultaneously. Just as all asset classes have been going up together, they seem destined to go down together as hefty valuations and disappearing liquidity prove a toxic mix.

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Source: Hedge Fund Leverage: Worse Than You Think