Disappointing hedge fund returns this year have significantly upped the amount of leverage some hedge funds of funds — primarily those catering to impatient high-net-worth investors — are willing to use to goose returns.
The main culprits, according to sources, are several non-U.S. banks offering hedge funds of funds with leverage as high as 5:1 or 4:1. Those funds collectively have up to $100 billion to invest when leverage is factored in.
If these funds run into liquidity problems, institutional investors will be among the many victims.
For the 12 months ended Nov. 30, the performance of funds of funds trailed that of single hedge fund managers by 256 basis points, according to Hedge Fund Research Inc., Chicago.
Managers are compensating by "borrowing to improve returns by adding more managers. The hedge fund-of-funds manager is like a coach who wants to send more men on to the field at exactly the wrong time," said John Matwey, head of alternative products at RiskMetrics Group, New York, a risk management consultant and systems provider.
By "wrong time," Mr. Matwey means they are adding leverage at the same time their underlying hedge fund managers are reducing it.