By William G. Ferrell
It takes a lot of risk to lose a lot of money. The easiest formula for disaster is to take ill-advised directional bets and apply leverage.
Such has been the underlying reason for most of the well-publicized blowups in the hedge fund arena. But in the analysis of the leverage often associated with the mishaps, the reaction of many institutional investors is to design rules to reduce or eliminate such exposure. The problem is, the rules often miss the real issues and often overlook valuable opportunities. The parallel would be to witness an electrical accident and discard all the kitchen appliances.
If institutional investors could continue to live with equities and fixed-income investments, with occasional commitments to real estate and private equity, and be able to generate steady growth, they would. The problem is that equity investments and those exposures that perform in a similar fashion are extremely volatile and not always profitable. The Wall Street Journal recently avoided the volatility calculation by pointing out that the stock market has a lot more 2% up days and 2% down days than it used to. In other words, the investors deserve a greater return because the risks are higher. As we all learned over the past decade, the good times are great and the bad times, a nightmare. And the volatility of the volatility itself is all over the map. As recently as last March, the volatility of the S&P 500 stood at more than 30%.
If we begin with the reasons institutions are following the lead of wealthy investors and endowments into the hedge fund world, we can simplify the explanation.
Wealthy investors have been allocating investments to hedge funds for decades in ever-growing proportions. Why? Individual investors' primary concern is the preservation of their capital. Because individuals hate to lose money, they do not tend to care about the relative performance of any index if their portfolio is headed south. Improving investment performance in all kinds of equity markets led them to long-short strategies, and their successful investment experience leads them to larger allocations. The truth is, absolute-return strategies provide valuable diversification from traditional investments.
Hedge funds are different in a very important and not-well-understood way. The funds come in a variety of strategy buckets that produce returns that do not correlate. Combining non-correlated strategies creates a portfolio of hedge funds capable of producing a very low and uncommonly stable level of volatility. It is this characteristic of hedge funds that makes them so useful as a competent, reliable diversifier. If a portfolio manager is successful at selecting talented managers within a framework of diverse strategies, the volatility of the overall portfolio can be held to levels far below traditional investments. The problem is, as the volatility shrinks, the diversification value goes with it, and even a great Sharpe ratio will not substantially improve overall pension performance if the volatility is too low.
Diversification should not be confused with "watering down" risk and return. In order for any new investment to provide real value to a portfolio, the risk tolerance and return potential should be on equal footing with the rest of the institution's holdings.
Enter leverage. When a portfolio is diversified to the point where volatility is not only low, but also stable, financial engineering can create a powerful investment program. First, one has to create the most efficient structure to reduce costs for all parties. Then, it is essential to find a knowledgeable and experienced credit provider. When properly constructed and executed, inexpensive leverage will increase the size and diversification of the underlying portfolio and generate above-market returns with volatility levels still well below traditional investments.
The accompanying graph depicts a typical efficient frontier of a diversified portfolio. The unique characteristic of a hedge fund component of a portfolio is that the return/risk relationship can be stabilized through careful diversi- fication of strategies and managers. With risk characteristics that are stable at the left side of the frontier, an efficient leverage structure can push performance along a tangent line as shown, resulting in a return above the frontier. The result is improved portfolio stability and performance.
Leverage is only dangerous when applied to investments with high or potentially high volatility. The key to leverage is employing it prudently to assets with stable, low volatility to make the most of a portfolio managed to maximize the Sharpe ratio. When pensions use risk allocation tools to manage their portfolios, their models will always push them in the direction of low correlations with the best Sharpe ratios. Diversification enhances long-term performance. Leveraging stable portfolios is a conservative way of making a non-correlated Sharpe ratio work harder to improve the overall pension performance.
The same investors who establish rules against leverage in hedge funds will invest in equities of banks and investment banks that employ enormous amounts of leverage in their balance sheets. Apparently they believe that the management of these firms properly diversify and manage the risks attributable to the portfolio of businesses that use the borrowed money. Perhaps they should place similar confidence in competent fund-of-funds managers who understand these concepts and know how to implement them.
William G. Ferrell is president and chief executive officer of Ferrell Capital Management, an alternative asset and risk-management firm in Greenwich, Conn.