Introduction to Hedge Funds

Summary of Lecture
This lecture will define what hedge funds are, discuss some of the key strategies that hedge fund managers
employ and will introduce some of the important vocabulary and quantitative tools used by hedge fund
managers. The accompanying reading for this lecture is Hedge Funds Demystified: Their Potential Role in
Institutional Portfolios. I thank the Pension and Endowment Forum of Goldman Sachs & Co. for kindly
granting permission for me to reproduce this document for use by the class. A portion of this lecture is
drawn from this document.

Types of Investment Funds

There are many types of investment funds besides hedge funds, and to place hedge funds more precisely in
the broader context of different funds, it is a good idea to define several other sorts of funds. In this section
we will talk about:

• Mutual funds
• Pension funds
• Hedge funds

Mutual Funds

Mutual funds are actually investment companies, that is, they are firms that collect
investments from investors and professionally invest money on behalf of investors.
Investment companies collect fees from investors, usually drawn directly out of the
investment, as a fee for the service of investment. There are primarily three types of fees an
investment company will charge:

• Up-front fees: these are fees charged for the collection of assets. In the world of mutual funds,
these are often known as sales loads.
• Management fees: these are fees charged for the on-going service of investing assets.
• Performance fees: these fees are a "cut" of the profits of investing. Performance fees are assessed
on the "upside" portion of the fund value, that is, on the portion of the value of the fund due to
investment return. For example, if an investor invests $100 in a fund and the fund value rises to
$120, then a performance fee may be charged on the $20 upside.

Mutual funds come in two varieties: closed end and open end. Open end mutual funds are investment
companies that continually offer new shares of the fund to the public for investment and stand ready to
redeem outstanding shares at the net-asset value (NAV) of the fund. In this sense, the company is the unique
market maker of shares in the company. They will sell or buy the shares every day. Mutual funds sell their
shares at the fund net-asset value per share, which may be regarded as the value of the investment in the
fund. It is calculated by taking the value of all investments in the fund less any liabilities (such as fees)
divided by the total number of outstanding shares.

Mutual funds are regulated investment companies. In particular, they are regulated by the Investment
Company Acts of 1940 and 1970. The 1940 Act regulates certain aspect of a fund's operations including
financial statements, investment goals, personnel, debt, and managers. The 1970 Act regulates sales
charges (i.e., sales load and in particular the maximum sales load) and fees of mutual funds. The main point
that concerns us in this lecture is that mutual funds are tightly regulated entities, a fact which is not the case
for hedge funds.

Note that open end mutual funds cannot be traded in a secondary market. Their values are determined by
the investment company (mutual fund company) and the company is required (by the Act) to buy and sell
the shares of the company at the NAV. Two key pieces of terminology concerning all funds are:

• Inflows: this is the flow of money into a fund

• Outflows: this is the flow of money out of a fund

Closed-end mutual funds unlike open end funds are traded in a secondary market. Such funds are distinct
from open end funds and work as follows. The fund issues a limited number of shares and does not redeem
the shares. Rather, the company publishes information about its NAV and the shares are traded on a
secondary market or through an over-the-counter market. In this sense, investors purchases shares of closed
end funds much in the same way they purchase shares of stock and for similar reasons. An important
feature of closed end funds is that their market values and net-asset values may differ. This is because the
net-asset value, determined by the value of the investments in the fund, may be different than the value (per
share) that investors are willing to pay for the fund. A closed-end fund whose market value is less than its
NAV is said to be trading at a discount.

Pension Funds
A pension fund is an investment company that manages the assets of employees of a company and
disburses the assets to employees upon retirement. Contributions to the fund by both employer and
employee finance the pension fund assets. There are two main types of pension funds:

• Defined Benefit: these funds manage their assets and set their investment goals according to a set
of guidelines that define the type of payouts they will make to employees after retirement.
• Defined Contribution: these funds manage their assets according to a defined set of rules of how
an employer's contributions to the fund are to be made.

I bring up pension funds in this lecture for two reasons. First, they are a type of investment fund and
therefore knowledge of them helps to reduce confusion about what and what not a pension fund is, and
second, pension funds are large investors in hedge funds. Moreover, the pension industry has been growing
world wide for some time; as a result has an impact on capital markets, as expressed in the following quote:

Institutional investors can influence the demand for capital-market instruments in several ways: by
increasing the total supply of saving, by influencing the rest of the personal sector's portfolio
distribution between bank deposits and securities, and via the institutions' own portfolio choices.

Pension Funds, E. P. Davis, Oxford 1997

Another point concerning the relationship between hedge funds and pension fund investment is the need for
financial innovation, as Davis points out:

The process of financial innovation-the invention and marketing of new financial instruments
which repackage risk or return streams-has been closely related to the development of pension
funds.

Pension Funds, E. P. Davis, Oxford 1997

Pension funds are often referred to as pension plans, and the organizations that establish pension plans
(such as private or public companies) are referred to as "plan sponsors". US Pension funds are regulated by
the important ERISA Act of 1974 (Employee Retirement Income Security Act), and this has implications
on how the monies coming from a pension fund can be invested, how they are to be disbursed, as well as
the financial and fiduciary standards of many of the participants in the pension plan world. We can only
briefly discuss ERISA here, but the full text of the act can be found on the internet at
http://www.benefitslink.com/erisa.

The act begins with the following statement:

The Congress finds that the growth in size, scope, and numbers of employee benefit plans in
recent years has been rapid and substantial; that the operational scope and economic impact of
such plans is increasingly interstate; that the continued well-being and security of millions of
employees and their dependents are directly affected by these plans; that they are affected with a
national public interest; that they have become an important factor affecting the stability of
employment and the successful development of industrial relations; that they have become an
important factor in commerce because of the interstate character of their activities, and of the
activities of their participants, and the employers, employee organizations ... that owing to the lack
of employee information and adequate safeguards concerning their operation, it is desirable in the
interests of employees and their beneficiaries, and to provide for the general welfare and the free
flow of commerce, that disclosure be made and safeguards be provided with respect to the
establishment, operation and administration of such plans; that they substantially affect the
revenues of the United States because they are afforded preferential Federal tax treatment; that
despite the enormous growth in such plans many employees with long years of employment are
losing anticipated retirement benefits owing to the lack of vesting provisions in such plans; that
owing to the inadequacy of current minimum standard, the soundness and stability of plans with
respect to adequate funds to pay promised benefits may be endangered ...

Summarizing the US governments reasons for regulating the pension plan industry, we see:

• Pension plans are vital to the welfare of the US economy

• Profit on capital gains in pension plans receive preferential tax treatment and therefore affect the
tax revenue of the US government

The second point is important for investment funds: ERISA money, that is, monies invested by pension
plans, receives different tax treatment vis-a-vis capital gains. Moreover, pension plans have three
alternatives with regard to how they manage their assets:

• Manage the pension assets itself

• Distribute the pension assets to external money managers
• Use a combination of the first two

Two important points when comparing pension funds as investors in hedge funds versus individuals as
investors in hedge funds are 1) fees and 2) tax treatment. Pension funds typically pay fees for assets under
management that are well below standard hedge fund fees. For example, Frank Fabozzi in Investment
Management (Prentice Hall, 1995) reports that a study in 1991 found that public pension funds pay an
average of .31% (31 bps) to have their external assets managed (that is, they pay .31% of total assets under
management as management fee) and private pension funds pay .41% (41 bps).

As such, pension funds have different investment goals relative to individual investors. As many hedge
funds draw from pension plans for investment capital, understanding the investment goals and rules of
pension plans is an important aspect of hedge fund marketing.
More on Tax Treatment of Pension Funds
The following brief discussion on tax treatment of pension funds is taken from Pension Funds, E. P. Davis,
Oxford 1997. Broadly speaking there are three different ways a pension fund can be taxed, depending on
which part of the pension monies are taxed. From this point of view, pension money is divided into three
pieces: contributions (the money going into the fund) and income (the increase in the funds value due to
asset appreciation), and benefits (the money coming out of the fund to pay employees upon retirement, or
withdrawal from the plan). Each piece may either be exempt (E) or taxed (T).

• Exemption of contributions and income, but taxation on benefits (EET)

• Taxation of contributions only (TEE)
• Taxation of benefits only (EET)

A contribution to a pension plan is said to be tax free if the income to the individual or employer that goes
to the pension fund is not taxed. For example, suppose a US employee makes $50,000 per year and
contributes $2,000 to his or her pension fund in a given tax year. If this contribution is tax free, then the
employee's taxable income that year is $48,000.

The US follows what is basically an EET taxation plan for pension funds, though there are limits on the
level of tax-free contributions for DC plans. Such contributions are limited to $30,000 per annum. For DB
plans, the amount of benefits that may be paid to an individual is limited to an "indexed ceiling", that is, the
maximum level increases with a pre-defined index level.

Most countries globally follow an EET-like plan. The following table may be of interest:

Country Form of Taxation

EET: contributions and asset returns tax free.
USA
Benefits taxed.
UK EET
TET: Employers' contributions taxed as
Germany wages; employees' contributions and asset
returns tax free. Benefits taxed at a low rate.
ETT: Contributions tax free. Tax on asset
Japan
returns, except for tax-free lump sum.
Canada EET:
Netherlands EET
Sweden ETT
ETT: Contributions tax free. Tax on real
Denmark asset returns. Benefits taxed, including
including 40$ of lump-sum payments.
Switzerland EET
TTT: Contributions, asset return, and
Australia
benefits taxed.
France E(E)T
Italy EET
Source: Pension Funds, E. P. Davis, Oxford 1997

Investment Implications
Depending on the particular taxation rules applied to a hedge fund, the plan sponsor will view various
investment styles differently. For example, if a government taxes realized income on capital gains (i.e.,
Australia) then a high turnover investment strategy (i.e., lots of capital gains) would be tax-disadvantageous
to a pension fund. In the US, due to the EET approach to taxation, capital gains are not taxed, and plan
sponsors do not have to look for "tax efficient" investment strategies.

Hedge Funds
The first thing to know about hedge funds is that the term hedge fund is not a legal term, but rather an
industry term. What a hedge fund is, therefore, is subject to some amount of interpretation. Consider a few
definitions. From Wall Street Words Houghton & Miflin 1997:

A very specialized, volatility open-end investment company that permits the manager to use a
variety of investment techniques usually prohibited in other types of funds. These techniques
include borrowing money, selling short and using options. Hedge funds offer investors the
possibility of extraordinary gains with above average risk.

From Hedge Funds Demystified, Goldman Sachs & Co.:

The term "hedge fund" includes a multitude of skill-based investment strategies with a broad range
of risk and return objectives. A common element is the use of investment and risk management
skills to seek positive returns regardless of market direction.

From the VAN Hedge Fund Advisors International web page:

A U.S. "hedge fund" usually is a U.S. private investment partnership invested primarily in publicly
traded securities or financial derivatives.

From the Hennessee Group LLC Web page:

A hedge fund is a "pool" of capital for accredited investors only and organized using the limited partnership
legal structure... the general partner is usually the money manager and is likely to have a very high
percentage of his/her own net worth invested in the fund.

As you can see, the definitions above focus on several aspects of investment companies known as hedge
funds:

• legal structure
• investment strategy
• investor pool

All three components are important in understanding hedge funds. To go further let's discuss first what
hedge funds are and what some of their salient features are:

• Hedge funds are legally limited partnerships.

 • Hedge funds are unregistered (i.e., unregistered with the SEC) investment companies. That is, they
are not regulated by the SEC (more on this later).
• Hedge funds can be users of a variety of investment strategies and products, including options,
future, swaps and short selling.
• Hedge funds often employ leverage, in that the amount of notional market exposure often exceeds
the investment capital of the fund.
• Hedge funds have limited liquidity. Typically investors can only get into funds on certain dates
and can only get their money out of funds on certain dates.

Who invests in hedge funds?

• Wealthy individuals. For an individual to invest in an unregistered investment company, the SEC
must deem an individual to be an accredited investors (a defined by SEC rule 501 of Regulation
D. The full text of this rule may be found at http://www.solarattic.com/rule501.htm). The rule
includes the following points for an individual:
o The individual must have at the time of investment a net worth (or joint net worth with
spouse) exceeding $1,000,000, or
o The individual must have individual income exceeding $200,000 in each of the two most
recent years or joint income with spouse exceeding $300,000 in each of the two most
recent years, and must have a "reasonable expectation" of reaching the same level in the
coming year.

And the rule contains the following points for an organization, corporation or other such entity:

• The organization must have total assets in excess of $5,000,000, or

• The organization's owners must be accredited investors.

• Endowments, e.g., the Wall Street Journal (December 8, 1998) and others report that the
University of Pittsburgh made a $5 million investment in Long Term Capital
• Pension Funds, e.g., Pension & Investments magazine regularly reports of pension fund activity
investing in new hedge funds. For example:
o Consolidated Paper's $650m pension fund added $10m in hedge fund investments in
November
o The University of Michigan hired four hedge fund managers to manage $100m of its
$2.5bn pension fund, and P&I reports that University of Michigan has a total of about
$300m invested with hedge funds.
• Other Hedge Funds: Some hedge funds invest in other hedge funds, including offering Funds of
Funds, that is, they strategically allocate their capital to other funds. Pension and Investments
(November 30, 1998) reports that Grosvenor Capital Management invested $7m in Long Term
Capital Management:

Grosvenor Capital Management, LP, a big, highly secretive hedge fund player, was stung
by an estimated $7m investment in Long-Term Capital Management LP, and reportedly
has been hit with redemptions following poor third-quarter performance.
Grosvenor feels hedge fund pain, Pension & Investments, November 30, 1998

One important item that none of the definitions covered was hedge fund fee structures, which is, in my
opinion, a key distinguishing feature of hedge funds versus in particular mutual funds. Hedge funds almost
always have a fee structure that includes both a fixed fee and a management fee. The fixed fee usually
ranges between 1 and 2% of assets under management and the management fee ranges between 20 and
25% of upside performance. As hedge funds are unregulated, these ranges are often exceeded, and can be
as high as 5% fixed fee and 25% management fee. Hedge fund fees are often quoted in language such as "2
and 20" meaning 2% fixed fee and 20% management fee. There are two additional important points about
hedge fund fees:

• the benchmark
• high water mark

The performance fee is sometimes calculated net of a benchmark. That is, the returns that fees are paid on
are sometimes only those returns in excess of some benchmark. Sometimes the benchmark is a risk-free
interest rate such as LIBOR (often called the cash benchmark, meaning performance fees are paid on the
profit that would be made in excess of an investment in cash) and other times it is a market index such as
the MSCI World Index or the S&P 500 index.

Example: Suppose at the beginning of year 1 a hedge fund has a net asset value of 100, and throughout the
year the fund realizes a 25% return, raising the net asset value to 125. Then if an investor entered the fund
with a $1,000,000 investment at the beginning of year 1 then his or her "shares" would be worth
$1,250,000 gross of fees. If the benchmark was cash, say 5%, then the fees would be paid on the $200,000
upside in excess of cash. That is, the first 5% of the return would not have to have fees paid on it. If the fees
were 2 and 20, then the investor would pay $20,000 in fixed fee (2%) and 20% of the upside above cash,
that is, an additional $40,000 for a total of $60,000 in fees. This would make the investment value, gross of
fees, equal to $1,190,000.

The high water mark is an important concept: investors in hedge funds enter the fund at a certain net asset
value, which we'll call the entering NAV. If the fund loses money in a given year and then makes back that
money in a subsequent year, the investor is usually not required to pay a management fee on any portion of
the upside in the subsequent year that was below the entering NAV.

Example: Suppose an investor enters a hedge fund with a $1,000,000 at the beginning of year 1, and in that
year the fund is down 20%, that is, the value of the investment drops to $800,000 gross of fees. The
investor still pays the management fee (that is why it is called a fixed fee), but the investor pays no
management fee. Now suppose that after year two the investment value is up to $1,200,000, representing
over a 30% gain in year two for the fund. The investor, nevertheless, only pays a management fee on
$200,000, that is, he or she only pays a fee on the amount in excess of the entering NAV. The entering
NAV in this case is called the high water mark. In subsequent years if there is a drop in NAV, the new high
water mark will be the entering NAV of the previous year, or the previous high water mark, whichever is
greater.

Liquidity

Hedge funds, unlike mutual funds, are not able to stand ready to buy and sell shares on any
given date. Rather they have two forms of liquidity constraints that they impose on
investors:

• Liquidity dates
• Lockup
• Minimum investment

Liquidity dates refer to pre-specified times of the year when an investor is allowed to redeem shares. Hedge
funds typically have quarterly liquidity dates, but yearly liquidity dates are not unheard of. Moreover, it is
often required that investors give advanced notice of the desired to redeem: these redemption notices are
often required 30 days in advance of actual redemption. Here is a quote from the November 16, 1998 issue
of Pension & Investments, commenting on hedge fund redemptions:
 Judgement day looms for hedge fund managers as they ponder the possibility of mass redemptions
following market volatility and recent hedge fund failures.

Since most U.S. hedge funds allow redemptions only at year end, and require a minimum 30-day
notice, hedge fund managers find themselves on the cusp of the redemption period not knowing
what to expect.

Offshore hedge funds, which are more liquid than their U.S. counterparts, already have
experienced relatively large redemptions.
Hedge funds fear redemption season, Pension & Investments November 16, 1998

Lockup refers to the initial amount of time an investor is required to keep his or her money in the fund
before redeem shares. Lockup therefore represents a commitment to keep initial investment in a fund for a
period of time. Once the lockup period is over, the investor is free to redeem shares on any liquidity date.
The length of the lockup period represents a cushion to the hedge fund manager, especially a new one. If
the hedge fund is unlucky enough to experience a drawdown (a sharp reduction in net asset value) after the
launching of his or her fund, then the lockup period will force investors to stay in the fund rather than bail
out. The ability for a hedge fund to demand a long lockup period and still raise a significant amount of
money depends a great deal on the quality and reputation of the hedge fund as well as the market savvy of
the marketers of the fund. For example, Long Term Capital Management was able to require a three year
lockup from investors. The Wall Street Journal in How Salesmanship and Brainpower Failed to Save
Long-Term Capital November 16, 1998 reports that John Meriwether, manager of Long Term Capital

... wanted some stiff restrictions. He insisted that investors not be allowed to withdraw money for
at least three years (Most hedge funds allow investors to withdraw annually, and in some cases
quarterly.) The fund also required a $10 million minimum - one of the highest in the industry.

Then there were the sky-high fees: an annual management charge of 2% of assets, plus 25% of profits,
compared with 1% and 20% respectively, for most of the industry.

Legal Structure
U.S. hedge funds are structured as limited partnerships. A limited partnership is characterized
by the fact that it has two types of partners:

• General partners (GP's)

• Limited partners (LP's)

Limited partners have limited liability with respect to the creditors of the partnership. In other words, the
extent of the liability of a limited partner is the partner's investment. In the context of hedge funds, limited
partners buy shares in the "corporation" (the hedge fund) and the value of the shares, gross of fees, are tied
to the net asset value of the fund. In practical terms, the general partners run the hedge fund. They are often
referred to as the hedge fund manager. The limited partners are the investors.

The Hedge Fund Industry

It is important to understand the magnitude of the hedge fund industry and the sizes of some of the key
players in the industry. "Hedge Funds Demystified" estimates that the size of the whole industry is
approximately $400bn, and that the investor pool is dominated by wealthy individuals (accredited
investors), with pension fund interest increasing. "Hedge Funds Demystified" also notes that it is difficult
to accurately assess the size of the industry, so this number should be read as mainly an indication of the
order of magnitude. To get a sense of where this stands, consider the pension fund industry by contrast.
Davis, in Pension Funds, reports that as of year end 1991, the US pension fund industry's assets were at
least $2.9 trillion. In other countries, the number was less for two reasons: the pension fund industry
contributes less assets as a percentage of GDP than the US (except Germany and Switzerland) and the US
GDP is much larger than other countries. Nevertheless, the global pension fund industry (as of year end
1991) was estimated at approximately $4.2 trillion. The numbers since then have surely grown, but I
currently do not have more up-to-date numbers.

Types of Hedge Funds

Hedge funds are generally classified according to the type of investment strategy they run. Below we
review the major types of strategies, but refer members of the class to "Hedge Funds Demystified" for
greater detail.

Market Neutral (or Relative Value) Funds

Market neutral funds attempt to produce return series that have no or low correlation with traditional
markets such as the US equity or fixed income markets. Market neutral strategies are characterized less by
what they invest in than by the nature of the returns. They often are highly quantitative in their portfolio
construction process, and market themselves as an investment that can improve the overall risk/return
structure of a portfolio of investments. Market neutral funds should not be confused with Long/Short
investment strategies (see below). The key feature of market neutral funds are the low correlation between
their returns and the traditional asset's.

Event Driven Funds

Event driven funds seek to make profitable investments by investing in a timely manner in securities that
are presently affected by particular events. Such events include distressed debt investing, merger arbitrage
(sometimes called risk arbitrage) and corporate spin-offs and restructuring.

Long/Short Funds
Funds employing long/short strategies generally invest in equity and fixed income securities taking
directional bets on either an individual security, sector or country level. For example, a fund might do
pairs trading, and buy stocks that they think will move up and sell stocks they think will move down. Or go
long sectors they think will go up and short countries they think will go down. Long/Short strategies are not
automatically market neutral. That is, a long/short strategy can have significant correlation with traditional
markets, and surprisingly have seen large down turns in exactly the same times as major market downturns.
For example, Pension & Investments reported on November 30, 1998:

Many long-short managers, which aim to profit from going long on stellar stocks and selling short equity
albatrosses, typically use traditional stock valuation factors such as price-to-earnings and price-to-bok value
ratios in their mathematical models to cull the winners from the losers. Unfortunately for them, when the
market ran into turbulence in late July and August, investors sought safe haven in some of the largest-but
expensive-stocks that these models had rejected as overpriced.

Then, after the Federal Reserve Bank began easing interest rates in late September, investors rushed to buy
small-capitalization, high-octane stocks that had been neglected in favor of large cap stocks for most of the
year. ... As a result, some market long-short managers got hit with a double-whammy.
Tactical Trading
Quoting from "Hedge Funds Demystified":

Tactical trading refers to strategies that speculate on the direction of market prices of currencies,
commodities, equities and/or bonds. Managers typically are either systematic or discretionary.
Systematic managers are primarily trend followers who rely on computer models based on
technical analysis. Discretionary managers usually take a less quantitative approach and rely on
both fundamental and technical analysis. This is the most volatile sector in terms of performance
because many managers combine long and/or short positions with leverage to maximize returns...

The Hedge Fund Industry and Quantitative Methods

Quantitative methods have been successfully applied in the hedge fund industry to improve returns, and
control risk. That said, there have been striking failures of seemingly quantitatively driven funds (such as
Long-Term Capital). Some of the most quantitatively driven strategies occur in the Market Neutral/Relative
Value Sector of the Hedge Fund World, so we will exam this sector in more detail by discussing some of
the specific types of strategies they employ. The following is a list of important and quantitatively driven
market neutral/relative value strategies. I refer you to "Hedge Funds Demystified" for a detailed description
of each:

• Fixed income arbitrage

• Covertible bond arbitrage
• Mortgage backed security arbitrage
• Derivatives Arbitrage
• Market Neutral Long/Short Equity Strategies

Hedge Fund Returns

As hedge funds are often viewed as providing returns that are "cheap" relative to risk, their performance is
usually evaluated on a risk-adjusted return basis. The common number that is quoted is the Sharpe Ratio
which is the ratio of annualized excess returns to the annualized standard deviation of returns. The
following repeats the data in Table 7 of "Hedge Funds Demystified" and gives an idea of the relative
performance of hedge funds compared with some standard indexes over the period January 1993 -
December 1997. The table represents returns on each Hedge Fund Sector, that is, the returns and standard
deviations in each column represents the returns that were realized on an equal weighted investment
portfolio of all the hedge funds in a given sector.

FT/S&P
Market Neutral Event Driven Equity Tactical Lehman
Actuaries World
Funds (38 Funds (49 Long/Short (89 Trading (101 S&P 500 Aggregate Bond
(USD
Funds) Funds) Funds) Funds) Index
Perspective)

Compound
13.37% 17.25% 19.29% 19.48% 20.25% 15.18% 7.48%
Return
Standard
1.86% 3.12% 7.20% 9.97% 10.66% 10.88% 4.14%
Deviation
Sharpe Ratio 4.69 4.05 2.07 1.54 1.52 1.03 .7
Leverage
The final point of this lecture is the notion of leverage in hedge funds. Leverage has many different precise
definitions, but all of them attempt to measure the amount of assets being funded by each investment dollar.
Leverage, especially in the days following the Long-Term Capital bailout, has been in the press a lot. There
are two fundamentally different ways of measuring leverage:

• Total long market value divided by total investment capital

• Total long market value plus total short market value divided by investment capital

Consider two fictitious funds with the following investments

FUND A FUND B
Long Short Long Short
$100 $0 $100 $100

Suppose each fund has $10 of investment capital. First of all, fund A is leverage 10 to 1
in either definition of leverage, while fund B is leveraged 10 to 1 in the first definition,
but 20 to 1 in the second. What are the risks in holding each fund?

First, let's examine the risks we can enumerate:

• Fund A: for every dollar of downward movement the Long position moves, the
fund loses 10% of its capital. That is, for every 1% move in the long market
value, there is a 10% move in the value of investment capital.
• Fund B: for every dollar movement in either the long market value or the short
market value, there is a 10% change in the value of investment capital.

Thus, from one point of view, the position of Fund B might be regarded as more risky
than the position of Fund A. Why? Because Fund B has essentially $200 of potential
market movements available, while Fund A only has $100. But, suppose the short
position in fund B is actually a hedge against the movement of the long position. That is,
suppose the short position is highly correlated with the long position so that the short
position is risk-reducing relative to the long position. In this case, the risk of fund B may
be regarded as less than the risk of fund A. An immediate conclusion of this example is
that it is difficult to assess from leverage alone the level of risk inherent in a fund. To
form a more accurate understanding of risk requires an understanding of the distribution
of future returns of a fund.

Put another way, the information we provide here cannot in itself adequately express the
risk of the fund. So, then, why don't people look at the risk of funds (e.g., Value at Risk
or some other risk measure) and forget about leverage altogether? Why do investors and
the press worry about leverage so much these days? The answer is that risk is deceptively
difficult to measure. Consider for example a highly leveraged fund that is long and short
securities that are highly correlated. Moreover, assume that this correlation is measured
using historical data, and that the fund is regarded as only moderately risky due to the
presumed stability of return correlations. If the fund is highly leveraged and it turns out
that the correlation assumptions are incorrect, then the damage of the incorrect analysis
will be severe precisely due to the miscalculation in the correlations. Put another way, the
damage of a mis-estimate of risk is itself leveraged when the fund is leveraged.