There are few practices that are as subject to preconceived notions as the L word. In modern finance this term refers, of course, to the use of leverage, which is widespread yet often misunderstood. One source of confusion is the different ways in which leverage is defined and measured. Another arises from one of its most basic and fundamental properties: adding leverage to an investment increases risk. Accordingly, investors often equate highly levered investments with high risk and will judge them as unsuitable without further analysis. Unfortunately this conclusion can be inaccurate if it fails to take into account potential differences in the risk of what is being levered.
These sources of confusion are particularly important to keep in mind when analyzing hedge funds. The measurement of leverage in a hedge fund trading strategy is more difficult than for a traditional investment strategy because of the sophisticated nature of the underlying securities and the complicated way in which they are put together in a portfolio. Further, leverage is often used by hedge funds not to add risk but to take offsetting positions in order to decrease the overall risk for investors.
The purpose of this article is to clarify how leverage is defined and used in various hedge fund and traditional investment strategies and to assess what levels of risk are produced. It finds that leverage ratios vary widely across hedge fund strategies and are generally higher than those of traditional investment strategies. The effect of leverage on risk, however, is not clear: several numerical examples demonstrate the risk for certain highly levered hedge fund strategies can be lower than for unlevered traditional investment strategies. Further, the empirical evidence suggests there is no discernible relationship between the use of leverage and the amount of risk in a given strategy, and that the investment risk of highly levered hedge fund strategies has generally been lower than for traditional long-only equity portfolios that do not use leverage. These findings imply that investors should not rely on leverage ratios alone as a proxy for risk when analyzing hedge funds but need to analyze the nature of the trading strategy in more detail. Read the full article.