Friday, May 1, 2009

High Sharpe Ratios And High Leverage Help Hedge Funds Survive

In a Jan. 24 article, Newsweek estimates that of the eight thousand hedge funds that existed in January 2008, 2,000 went out of business by January 2009 and another 2,000 will disappear by January 2010. What determines which funds stay in business and which funds will go by the wayside?

For the business to remain viable, revenues must be sufficient to cover expenses of running the business. The business of hedge funds is no exception. Once accounted for trading costs, a portion of revenues (80% on average) is paid out to investors in the fund, leaving the fund managers with “performance fees”. In addition, hedge fund managers may collect “management fees”: a fixed percentage of assets designated to cover administrative expenses of the fund regardless of performance.

Even the most cost-effective hedge fund operation faces employee salaries, costs of administrative services, trading costs, as well as legal and compliance expenses. The expenses easily run US$100,000 per average employee in base salaries and benefits plus negotiated incentive structure; in addition to the fixed cost overhead of office space and related expenses.

To compensate for these expenses, what is the minimum level of return on capital that an investment manager should generate each year to remain a going concern? The answer to this question depends on the leverage of the fund. Consider a fund with 5 employees. Fixed expenses of such a fund may total $600,000 per year, including salaries and office expenses. Suppose further that the fund charges 0.5% management fee on its capital equity and 20% incentive fee on returns it produces above the previous high value, or “watermark.” The minimum capital/return conditions for breaking even for such a fund under different leverage situations are shown in Figure 1. As illustrated in Figure 1, a $20 million unlevered fund with 2 employees needs to generate at least 12% return per annum in order to break even, while the same fund levered 500% (borrowing 4 times its investment equity) needs to generate just 3% per annum to survive.

Figure 1

The conventional wisdom, however, tells us that leverage increases the risk of losses. To evaluate the risk associated with higher leverage, we next consider the risks of losing at least 20% of the fund’s capital equity. As shown in the Figures 2 and 3, the probability of severe losses is much more dependent on the aggregate Sharpe ratio of the fund’s strategies than it is on the leverage used by the hedge fund.

Figure 2

Figure 3

The higher the Sharpe ratio, the lower is the probability of severe losses. As Figure 2 shows, while the annualized Sharpe Ratio of 0.5 for an unlevered fund expecting to make 20% per year translates into a 15% risk of losing at least 1/5 of the fund’s equity capital, levering the same fund nine-fold only doubles the risk of losing at least 1/5 of the fund. In comparison, the annualized Sharpe Ratio of 2.0 for an unlevered fund expecting to make 20% per year translates into a miniscule 0.1% risk of losing at least 1/5 of the fund’s equity capital, and levering the same fund only increases the risk of losing at least 1/5 of the fund to 1.5%, as shown in Figure 3.

Furthermore, as Figures 2 and 3 show, for any given Sharpe Ratio, the likelihood of severe losses actually increases with increasing expected returns, reflecting the wider dispersion of returns. From an investor perspective, this means that a 5% expected return with a Sharpe of 2 and above is much more preferable to a 35% expected return with a low Sharpe of, say, 0.5.

In summary, a hedge fund is more likely to survive if it has leverage and high Sharpe ratios. High leverage increases the likelihood of covering costs, and the high Sharpe ratio reduces the risk of a catastrophic loss.

(from Financial Alternatives, May 1, 2009)

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