Hedge funds ramp up leverage to boost returns

New York - Hedge funds' use of leverage in equities trading is near record levels after debt-fuelled strategies ballooned in recent years and an upturn in financial markets prompted riskier bets, according to two banking sources and recent client notes from major banks.

Fresh data compiled by Goldman Sachs, JPMorgan and Morgan Stanley, the three largest global prime brokerages, seen by Reuters in notes distributed to a restricted group of clients, show that leverage used to juice up returns is at, or close to, historical highs, depending on the bank.

The use of leverage by hedge funds in recent years has drawn more attention from regulators on the effect it could have on portfolios, markets and banks. The Federal Reserve's scenarios for its annual bank health check will start testing banks against a scenario in which big hedge funds fail, while the US Securities and Exchange Commission is asking hedge funds for more detailed and regular data on exposures.

“Leverage is definitely at a high in the macro (hedge fund) world,” said John Delano, an MD at Commonfund, which invests in hedge funds, who said this was fuelled by progress in bringing down inflation and investor confidence in artificial intelligence.

Goldman Sachs' note showed that hedge funds' leverage in equity positions was at almost three times their books compared with 2.35 times a year ago, and a record level over the past five years, the period the bank uses for comparison.

The data means that for every $100 of their own capital, the hedge funds had $300 in long and short positions.

JPMorgan showed current use of leverage — at roughly 2.7 times — is close to a peak reached since 2017 and higher than 98% of the time it has been tracked since then. Morgan Stanley also said leverage in the US was higher only 2% of the time when tracked in the last fourteen years.

The rise in leverage comes as hedge funds become more bullish after a stock rally which took off at the end of October, when investors started betting the Fed would soon move to cut interest rates. The S&P 500 has risen roughly 24% since then.

Barclays said in its note that hedge funds across different strategies are bullish. Global macro hedge funds are now long equities after unwinding short positions they had last year while systematic hedge funds are long different equity indexes. Equity long positions in so-called commodity trading advisers (CTAs), funds which use computers to follow price trends, “remain stretched,” Barclays added.

“The market is taking the view that everything is fine,” said Mario Unali, senior portfolio manager at Kairos Partners, who said he has observed the highest level of leverage for the last three years among systematic strategies, those that use computer models based on data to trade.

While traditional hedge funds that go long or short on stocks based on data analysis by people leveraged roughly two times their books, equity quantitative and multistrategy hedge funds were at 4.5 and 3.1 times, according to a JPMorgan estimate.

Since 2014, leveraged strategies have become more popular among investors, outpacing the asset growth seen across the industry. Multistrategy and quantitative comprise roughly 32% of the hedge fund space now versus 24% in 2014, according to hedge fund research firm PivotalPath.

Still, these strategies are overall seen as less risky as they tend to match long and short positions and are less exposed to the ups and downs of stock markets.

The use of higher leverage to bet on a continuing rally seems to be paying off so far. Equity hedge funds using systematic strategies posted 6.42% in gains in the first two months of this year, according to Goldman Sachs, outpacing the world stock index MSCI.

Edoardo Rulli, chief investment officer of UBS Hedge Fund Solutions, a fund of hedge funds, said current leverage levels are still manoeuvrable and are not one of his biggest concerns, as volatility is lower.

Still, he is keeping an eye on it. “Leverage is always a concern, so monitoring leverage is key. It can be deadly if combined with liquidity risk,” he said.

Reuters