Hidden leverage and portfolio policies

Increasingly, institutional investor portfolios hold futures and hedge funds. Both futures and hedge funds contain hidden leverage that might violate the spirit of the “policy” portfolio's fixed-income minimum.

Assume that an organization's “policy” portfolio is 50% to 70% stock and 30% to 50% short-term bank certificates of deposit (or U.S. Treasury bills). The portfolio's asset allocation must stay within these ranges.

In fact, a typical institution's “policy” portfolio would have a portion in fixed income, rather than short-term bank CDs or T-bills. The organization's debt holdings would have longer maturities, with a higher yield but also some volatility of principal.

For simplicity, however, I shall initially assume that the policy portfolio specifies short-term fixed-income instruments.

Short-term wash

Suppose the entity holds $1 in a stock index fund and $1 in a short-term bank CD, with no other assets or liabilities. That gives it a net worth of $2.

Assume that the investor borrows $1 short term from a bank to place an additional $1 in the stock index fund, with the following result:

Assets: $2 in a stock index fund, $1 in a short-term bank certificate of deposit.

Liabilities: $1 in short-term debt.

Net worth: $2.

Borrowing $1 from the bank is equivalent to liquidating the $1 bank CD. This is obvious if the institution borrows from the same bank that issues the CD. Suppose the loan and the certificate have the same maturity date: six months later. At the end of six months, the bank will pay the institution $1 plus interest on the certificate, but the institution will pay the bank $1 plus interest to repay the loan. Except for any slight difference in interest, the result is a wash.

Even if the certificate and the loan are at different banks, the result is the same. The bank loan and the certificate of deposit roughly cancel each other out.

In short, the following two balance sheets are roughly equivalent:

Assets: $2 in a stock index fund, $1 in a short-term bank certificate of deposit.

Liabilities: $1 in short-term debt.

Net worth: $2.

and

Assets: $2 in a stock index fund.

Liabilities: None.

Net worth: $2.

"Hidden" leverage

Two kinds of investments, stock index futures and hedge funds, may contain hidden leverage that frustrates the policy portfolio's fixed-income minimum. This article will consider each in turn.

First, the effect of the “embedded debt” in a stock index future.

Returning to the very first balance sheet, assume that the institution starts with the following:

Assets: $1 in a stock index fund, $1 in a short-term bank CD. It has no liabilities and, therefore, a net worth of $2.

The organization then buys a $1 stock index future. The balance sheet does not change. Technically, the stock index future is a contract and, therefore, not on the balance sheet as an asset or liability. Actually, however, the institution has added one form of “hidden” leverage: the “embedded” $1 debt in the stock index future.

The $1 stock index future is equivalent to borrowing $1 short term to purchase $1 of a stock index fund. This is because the price of the index future is determined by sellers of the instrument who borrow short term to buy the index for future delivery. One could view the instrument seller as the agent of the instrument buyer. On behalf of the buyer, the “agent” borrows to purchase the stock index fund. At “settlement,” the “agent” sells the “buyer's” index fund shares and repays the “buyer's” loan plus interest. If the balance is positive, the “agent” sends that amount to the “buyer.” If the balance is negative, the “agent” collects that amount from the “buyer.”

Because of the $1 stock index future with its $1 “embedded debt,” the organization's balance sheet is really the following:

Assets: $1 in the bank CD, $2 in a stock index fund (including $1 from the stock index future).

Liabilities: $1 in short-term embedded debt (from the stock index future).

Net worth: $2.

The $1 in short-term embedded debt roughly cancels out the $1 in the bank CD, with the following result:

Assets: $2 in a stock index fund (including $1 from the stock index future).

Liabilities: None.

Net worth: $2.

The institution has violated the spirit of its policy portfolio limits, which require at least 30% of the portfolio to be in short-term bank CDs or T-bills.

Now, I shall relax the assumption that the policy portfolio specifies short-term fixed-income instruments. Instead, I shall assume that the policy portfolio specifies long-term fixed-income obligations. Returning to the very first balance sheet, assume that the institution starts with the following:

Assets: $1 in stock index fund, $1 in long-term bonds.

Liabilities: None.

Net worth: $2.

As before, the organization then buys a $1 stock index future. The following de facto balance sheet results:

Assets: $1 in long-term bonds, $2 in a stock index fund (including $1 from the stock index future).

Liabilities: $1 in short-term embedded debt (from the stock index future).

Net worth: $2.

The institution in effect borrows $1 short term (through the embedded debt in the index future) and lends $1 long term (through its bond holdings). The entity gains only any difference between the cost of short-term borrowing and the return from long-term lending. The $1 in borrowing and $1 in lending still largely cancel each other out, with the following result:

Assets: $2 in a stock index fund (including $1 from the stock index future).

Liabilities: None.

Net worth: $2.

Again, the institution has violated the spirit of the 30% portfolio minimum in fixed-income obligations.

Effect of hedge funds

Hedge funds are a second possible source of “hidden leverage” that may frustrate the policy portfolio's fixed-income minimum. In a famous 1958 article, Professors Franco Modigliani and Merton Miller demonstrated the equivalence of corporate leverage and investors' personal leverage (under certain assumptions). In other words, an investor's borrowing to buy stock of a company with no debt is equivalent to an investor's holding shares of a company with corporate leverage. Normally, however, an institutional investor does not look at the leverage of the companies in which it holds stock and view this indirect leverage as canceling out the organization's fixed-income holdings.

Nevertheless, suppose the organization holds shares of an investment company that, through borrowing or derivatives, has substantial leverage. Because the investment company in effect holds securities on behalf of the institution, it might regard the investment company as an arm of the organization and view the investment company's borrowing as equivalent to that of the institution. The institutional investor might then view the investment company's borrowing as canceling out the organization's fixed-income holdings.

Suppose the organization holds a hedge fund that, through borrowing or derivatives, has substantial leverage. The institution could also view the hedge fund's leverage as canceling out the organization's fixed-income holdings and possibly moving the entity below (or further below) its policy portfolio minimum.

In short, an institution that purchases a $1 stock index future is in effect borrowing $1 to invest in a stock index fund. This $1 liability might roughly offset $1 of fixed-income holdings and sometimes violate the spirit of the organization's minimum percentage in fixed-income obligations.

Also, if the entity holds hedge funds, the hedge funds' own leverage may cause the organization to deviate below its minimum fixed-income allocation.

William K.S. Wang is a professor at the University of California, Hastings College of Law, San Francisco