July 28, 2011
Research Reveals Why Hedge Funds Are An Unlikely Large Source Of Systemic Risk
The Journal of Financial Economics recently published a paper by Andrew Ang, Chair, Ann F. Kaplan Professor of Business and Chair, Finance and Economics Division at Columbia Business School; Sergiy Gorovyy, PhD candidate, Columbia Business School; and Gregory B. van Inwegen, Head of Quantitative Research/Managing Director for Tailored Portfolio Group of Citi Private Bank, that was the first paper to formally investigate hedge fund leverage using actual hedge fund ratios. Contrary to popular belief, the researchers found that hedge funds, in general, are only modestly leveraged. The average hedge fund leverages its equity by two times. In addition, hedge fund leverage is counter"“cyclical to the leverage of the finance sector and large financial intermediaries. During the financial crisis, the leverage of investment banks spiked up to above 40 during the first quarter of 2009. During that time, the average hedge fund leverage was only 1.4, and hedge funds had started to substantially reduce their leverage in 2007 long before the onset of the financial crisis.
The relatively frequent and sophisticated use of leverage is a defining characteristic of the hedge fund industry. Yet, little is known about hedge fund leverage. Hedge funds are not required to report their activities to the same extent as mutual funds, pension funds, banks, insurance companies, and other financial institutions. In order to explore hedge fund leverage, the researchers studied actual leverage ratios of hedge funds"”the first study to obtain such information"”for a large cross section of funds. They studied both how hedge fund leverage has evolved over time for the whole hedge fund industry and various hedge fund sectors and the determinants of hedge fund leverage across funds, that is what makes one fund take different leverage from another fund. Finally, they compared hedge fund leverage to the leverage of listed financial companies.
These findings will be influential, as the research indicates hedge funds are unlikely to represent a large source of systemic risk. An important implication is that regulators should be more concerned with the traditional regulated finance sector, especially banks and large financial institutions which provide hedge funds with leverage, rather than hedge funds themselves.
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