Peering into the Black Box of Hedge Fund Risk
Lately that allure is fading. Old-fashioned equity returns blazed past hedge funds after the financial crisis and even bond funds — buoyed by lower interest rates — have performed better since then. Once-charmed institutional investors are rethinking things, attempting to reverse engineer hedge funds’ secret sauces and asking, “Can we replace you with cheaper robots?”
Regulators, as well, are trying to peer into the “black box” of the industry’s positions and strategies. Hedge funds must disclose what used to be closely guarded secrets — fund exposures, sources of borrowing and risk metrics — on a regular basis (quarterly for large funds, annually for small) to the U.S. Securities and Exchange Commission (SEC). The SEC keeps the data confidential but uses it to investigate funds, monitor risk and share with relevant parties.
One very relevant and very interested party is the Office of Financial Research (OFR), which is charged with promoting financial stability. Its recent Market Monitor analyzed some of the secret data and concluded that certain hedge funds “may create vulnerabilities that threaten financial stability,” owing to their high leverage and potentially illiquid holdings. A March 2016 OFR working paper “reveals significant wiggle-room” in the hedge fund disclosure form for measuring risk.
Leverage can be a good measure for a fund’s riskiness because it essentially multiplies the destruction caused by a given loss in the fund’s assets. But it is exceedingly difficult to determine how much leverage is toomuch. By the OFR’s account, median leverage employed by large hedge funds was 1.3, which on its face does not sound too concerning. Of course, outlier funds had higher levels: five-times at the 95th percentile and up to 10-times for a select few.
Is that excessive, from a financial stability perspective? It’s unclear; any forward-looking assessment without the benefit of hindsight is probabilistic. Leverage ratios vary by fund strategy, but there is a consensus that overall hedge fund leverage is lower today than before the crisis. This may partially explain the sector’s lower returns in recent years, but it is perhaps reassuring that more funds have not resorted to even greater levels to juice performance in a low-return environment.
The question of excessive leverage is also relative. Many banks were leveraged 20-times to 30-times before the financial crisis and are considered “safer” now in the high single digits. Imposing leverage caps on hedge funds potentially implicates other investment models operating outside the hedge fund space on similar principles. For instance, mortgage real estate investment trusts fund hundreds of billions of dollars of agency mortgage-backed securities using short-term financing (repos) at leverage ratios in the 5-times to 8-times range.
These are the kinds of tough judgment calls regulators face when trying to weigh financial stability against efficient capital allocation. Compared to mutual funds, where a crack-down on leverage through the use of derivatives is underway, hedge funds have some stability advantages. Their investor base should be more sophisticated and less panicky in the event of substantial losses. Even in the event of panic, hedge funds often have lock-up provisions that allow them to avoid fire sale losses and weather financial storms.
Ultimately, the hedge fund space is comprised of a number of mostly small funds. To the extent these funds pursue diverse and uncorrelated strategies, the hedge fund industry appears relatively more benign. To the extent these funds share common risk factors, however, or their correlations with risk assets rise in times of market turmoil, the sector poses greater risks.
The Financial Stability Oversight Council’s (FSOC) latest analysis of systemic risk and asset managers focuses heavily on the role hedge funds play, suggesting the industry will be top of mind for any regulatory policies affecting asset managers. While the SEC seems particularly focused on more retail-facing asset managers (mutual funds, ETFs) in 2016, it will be interesting to see whether the commission turns its attention toward a $3 trillion hedge fund industry when assessing market-wide concerns.