from Follow the Money

Are hedge funds (and others) taking on too much risk?

July 3, 2005

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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In order to try to generate hedge fund like returns in the low-return (global savings glut?) world.

LTCM, after all, started dabbling in Russia as the margins on its other, more conventional relative-value trades started to disappear.

The Times takes up the question today. This quote caught at least my attention.

Over the last year, though, the Federal Reserve and the I.M.F. have noticed that leverage is creeping back in some areas, probably because of heightened competitive pressure.

The trouble is that average leverage isn’t really a good indication of the risks involved. Even if the industry is generally healthy, a couple of very bad apples could spoil everything. After all, the Long Term Capital Management crisis started with just one fund, not the whole industry.

On that score, there has been talk on Wall Street about risky hedge funds. In particular, some traders who deal with hedge funds suspect that leverage in some cases today exceeds that of Long Term Capital Management. And borrowed money isn’t the only reason. Traders concern themselves with a broader measure called economic leverage, which takes borrowing into account but also includes risks like those arising from derivatives and other complex financial arrangements.

Something to watch, since, as the Times notes, the incentive to take big risks with other people’s money is always there.

The incentive to take risks with all that money is huge. A typical fee structure, called "2 and 20," gives managers 2 percent of the assets under management and 20 percent of gains realized by the fund. At large funds, this means that a single year’s winnings can set up the managers for life. But as more funds pile into the winning strategies of the past, competition inevitably shrinks profit margins. And that has tempted managers to find new, sometimes riskier ways to maintain their spectacular returns.

Worth watching. There is no more easy money left in the curve-flattening trade.

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