Leverage is an increasingly popular tool for investors of all sizes. Hedge funds have been at the center of attention when it comes to leverage, because a few have failed, leading the media to pay great attention to the drama surrounding such circumstances. Unfortunately though, too little consideration is given to the learning opportunities these failures represent for individual investors.

The fact is the mistakes of others, especially the purported intellectual and social elite of the hedge fund universe, offer wonderful examples of how not to use leverage. With that in mind, let's take a look at leveraged hedge fund strategies and the factors that can and do contribute to their failure.

SEE: Massive Hedge Fund Failures

The Strategies
To begin, consider the following two hedge fund strategies that entail substantial amounts of leverage:

Currency Carry Trade
The currency carry trade strategy is based on the principle of taking advantage of interest rate and currency differentials among the economies of the world. More specifically, it entails borrowing money in a nation (or currency) with low interest rates and investing in a nation (or currency) with high interest rates. On an absolute basis, this type of trade will only result in single-digit rates of return. However, leverage can quickly solve that dilemma.

SEE: Currency Carry Trades 101

Interestingly, this is one hedge fund strategy that any individual investor can perform with only a futures trading account. In fact, it is as simple as selling short a futures contract on the low interest rate currency (or borrowing at that rate) and going long a futures contract on the high interest rate currency (or investing at that rate). This is generally what hedge funds do, as futures markets are a very liquid and efficient means to implement this strategy.

SEE: Futures Fundamentals

Furthermore, given the very low margin requirements for futures contracts, it is easy to apply substantial amounts of leverage. To illustrate, consider the following example of a carry trade through futures contracts that assumes the following:

  • The initial outlay is $100.
  • $10 purchases $100 in notional carry trade exposure.
  • The remaining $90 stays in the money market as margin.
  • Cash rates are 4%.
  • The embedded cost of capital for the futures contract is 4%. (The embedded cost of capital is a drag on performance of futures contract. For example, if cash rates were 10% for an S&P 500 futures contract and you held the contract until maturity, your return would be the S&P 500's return less 10%.)
  • Short (or borrow) in a currency with a 1% yield (i.e., Japanese yen).
  • Long (or invest) in a currency with an 8% yield (i.e., New Zealand dollar).
  • The investment period is one year.
$100 in Notional Carry Trade Value/$10 in Futures Percent Dollars (USD)
-- -- --
Interest Paid on Borrowed Currency -1% ($1.0)
Interest Earned on Invested Currency 8% $8.0
Gross Positive Carry 7% $7.0
-- -- --
Embedded Cost of Capital -4% ($4.0)
Net Positive Carry 3% $3.0
-- -- --
Remaining $90 in Money Market -- --
Return 4% $3.6
-- -- --
Total Return on $100 Cash Investment 6.6% $6.6

Fixed Income Arbitrage
This hedge fund strategy is a bit more complicated and entails going long and short bonds with varying credit qualities and applying leverage to ratchet up returns. For example, a hedge fund may purchase very high quality corporate or mortgage-backed bonds using leverage. By doing this, they make an incremental returns for each bond purchased with leverage, assuming the cost of the leverage is less than the interest received on those bonds.

Furthermore, because purchasing bonds with leverage entails exposure to both interest rate and credit risk, the hedge fund will also short sell bonds for downside protection. More specifically, they will short bonds of a lower credit quality, assuming they will fall faster in value than high quality bonds if interest rates rise or credit markets deteriorate. This way, they can short fewer bonds than they are long, thereby producing a net positive rate of return, or a "positive carry." If structured properly, this trade creates a steady rate of return with relatively low volatility. This strategy is often referred to as an absolute return strategy.

Although these sorts of trades look great on paper and often work as planned for extended periods of time, they can and do fail. Generally speaking, the risk management side of any levered strategy is based on the historical movements and behaviors of the investment instrument(s) in question. Some risk management models are simple, while others are obscenely complex, but all of them rely on the assumption that past behavior patterns will be repeated within a reasonable degree of error. In the end, however, true risk management boils down to how well unprecedented or unexpected market behavior is predicted.

This is true for both multibillion dollar hedge funds and individual traders with a few thousand in options or futures contracts. Assuming markets behave as expected, levered investments may work out great. However, if markets behave outside of expectations, levered investments tend to break down and experience heavy losses over very short periods of time.

Lessons to Consider
This leads us to the first lesson individual investors need to learn about leverage:

Lesson No.1: Structure your levered positions to weather unprecedented and unexpected market behavior.

It is inevitable that you will at some point fail to predict the future accurately. Therefore, running into a situation where you experience heavy investment losses on a levered investment is something that needs to be anticipated, regardless of how intelligent you believe yourself (or your advisor) to be.

As is the case with hedge funds borrowing from banks or an individual borrowing on margin, margin calls are an undeniable eventuality of using leverage. If you look at the history of hedge funds that have blown up, not including cases of fraud, you will invariably find that all of these failures were a result of an inability to meet margin calls and of being forced out of investments at an inopportune time.

SEE: Margin Trading

Because hedge funds often tend to be levered at the total fund level, it is rarely the case they have substantial amounts of cash on the sidelines. This is probably the most important lesson to learn about leverage because it is the one thing you can prepare for with complete certainty.

Lesson No.2: Make sure you have sufficient cash or credit reserves to bail out your levered investment position.

In other words, it's fine to implement levered investment strategies as part of your overall portfolio diversification, but never lever your entire investment portfolio, especially not into a single or concentrated basket of positions.

There are many ways individual investors can introduce leverage into their portfolios, often through brokerage margin accounts or derivatives such as options and futures contracts. Moreover, individual investors can implement some hedge fund strategies such as the carry trade described above. Nonetheless, when doing so investors would be wise to learn from the mistakes of others in this regard.

Typically, hedge funds became too greedy, stretched too far for return and took on too much leverage. This can be the result of overconfidence. This sense of overconfidence is common, as people of all upbringings and educational backgrounds have a tendency to correlate their level of intelligence with the ability to predict the future. Unfortunately, this just isn't how the markets work. In fact, they will almost certainly behave outside of your expectations. As such, failure to predict market behavior accurately is the primary driver of failed levered investments when coupled with a lack of cash on the sidelines.

SEE: Brains Don't Always Bring The Bucks

The Bottom Line
The keys to using leverage effectively are very simple:

  1. Don't get greedy and reach for returns through too much leverage.
  2. Accept that you can't predict the future and appropriately model your trades. Also accept that this will likely diminish potential returns.
  3. Always make sure you have some backup cash or credit on the sidelines in case things go awry.

In the end, the most important thing to realize with leverage is that hawkish monitoring of your investments is essential because short-term market fluctuations can be fatal.

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