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Hidden Leverage

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Editor's Note: Minyanville is a community of people who share an interest of fiscal literacy. As perspective is an important aspect of our daily routine, we share this email with hopes that it adds balance to your process.

Prof. Succo -

While concerns about hedge-fund leverage usually focus on individual managers pumping up their bets, the report, by Optima Fund Management, highlights another layer of borrowed money in the industry that aids returns in good times but can cause trouble if performance sours.

This extra leverage is embedded in so-called structured products, which are types of derivatives based on an underlying group of hedge funds or a hedge-fund index. The products usually allow investors to borrow money, so, in theory, a $1 million investment could provide exposure to $4 million in a group of hedge funds.

Optima, a New York-based hedge-fund investment firm, concluded that about $50 billion, or 5% of total capital in the industry, is leveraged via structured products.

Another survey this month by Deutsche Bank found that more than half of hedge-fund investors are either using structured products or are considering them.

That's a concern, some experts said, because a period of sustained hedge-fund losses would trigger automatic redemptions that are built into these structured products.

That, in turn, could force managers of the underlying funds to sell positions to return cash. If some of those managers are leveraged themselves, the problem is magnified and could affect broader markets.

Lot's more here


Minyan Mish



MM-

Here is how it works.

A broker dealer arranges what is called a managed account at a hedge fund. This means that the funds invested are not pooled with other investors, but the positions are actually "owned" with the right to liquidate at any time by the investor. The hedge fund manager agrees to run these positions pari passu with the hedge fund's general fund.

The broker dealer is the investor in the hedge fund with the ultimate investor buying a structured product or swap that pays off returns and losses equal to 4 times the hedge fund returns less a financing cost on $3 million. The UI (ultimate investor) buys the note for $1 million; the broker dealer invests $4 million in the hedge fund.

In this way the UI is has a levered investment in the hedge fund of $4 million.

In order to protect their collateral (the hedge fund's positions), the broker dealer will liquidate the positions in the managed account if losses become significant enough. It is entirely up to the broker dealer at what point they can do this, although I would imagine these things are discussed up front and maybe even agreed to by the UI.

I can't say for certain on this last point because I do not allow such investments at my hedge fund. This added layer of leverage and control by outside investors would not allow me to manage risk appropriately.

This is another example of hidden leverage in the system. It is why I continue to warn of the risks even though those risks do not become manifest until after the fact.

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