Friday, 1 August 2014
Last updated 8 hours ago
Oct 8 2010 | 9:45am ET
Leveraged investments have gotten some bad press in the wake of the credit crisis, but Concordia Advisors CEO Basil Williams thinks they still have a place in investors’ portfolios.
New York-based Concordia Advisors, a multi-strategy hedge fund manager with $1 billion in assets under management and 17 years in the business, offers clients global relative value strategies in both the equity and fixed-income markets. Williams spoke with FINalternatives' Mary Campbell recently about what investors need to know about leverage.
You feel leveraged investments are the subject of both fear and confusion in today’s market, why is that?
Well I think for many years, leverage has been associated with risk and has been pegged as something that causes failure more often than not and especially post the credit crisis it seems to be exclusively associated with risk and…seen as public enemy number one. Our assessment is that blaming leverage is often unfounded due to a lack of a detailed understanding regarding how leverage is used to achieve better risk-adjusted returns. It’s an easy scapegoat—'They ran leverage strategies, that’s bad'—and when you dig into the world of leverage you have to really understand two things: what is it that you’re leveraging and how are you leveraging it. Simply put, our thesis is that if you’re applying leverage to highly liquid instruments and you have proper risk controls around the trading strategies that you enter—that you can easily increase or decrease your leverage with minimal transactions costs—application of leverage in this manner has a place in portfolio management.
Alternatively, if you’re applying leverage in instruments that, perhaps in good markets have liquidity but in bad markets don’t have liquidity, you then run into a problem if you’re trying to de-risk that portfolio in a stressed market condition when the transaction costs of de-risking are exacerbated by the leverage.
So, if I look at traditional strategies, strategies that involve the use of futures obviously have leverage embedded within them because futures contracts are leveraged instruments. Strategies that involve equities may have leverage of varying degrees, depending upon the regulatory scheme in which you operate. But generally speaking, equities, or at least large-cap equities, have high degrees of liquidity and if a position goes against one, one can sell down the position to meet the requisite margin calls that would have occurred. But when you get involved in leveraging instruments such as high-yield bonds, distressed bonds, convertible bonds, bank loans; in good markets …you can trade up and down, but in stressed markets the secondary markets for those instruments tend to seize up and using even modest degrees of leverage can cause one to get into trouble.
Is it just a question of what you leverage or is the degree of leverage also an issue?
Well, when you are determining what you lever, you have to ask yourself a couple of questions: the first question is, what is the volatility of the underlying asset? If the asset is a highly volatile asset, you don’t need a lot of leverage to deliver a lot of risk. If you’re leveraging a two-year treasury note, or a one-year treasury bill, an asset that’s quite stable in its price, you can apply a much greater amount of leverage to end up at the same risk point. The comparison I usually use is the volatility of a long-maturity, high-yield bond may be 15 or 20% over a year, where the volatility of a one-year treasury may be a half of 1% over a year...so one could apply 30 times leverage to the one-year treasury to get the same volatility that you would end up with in the case of a high-yield bond, or a stock, let’s say. So one’s a 30-times-leveraged investment, one’s a one-times-leveraged investment, at the end of the day, they have the same price risk.
Now that’s market risk, the question then is, if I ...want to take that trade off…or disinvest from that situation, well, a one-year treasury bill has pretty much infinite liquidity. An equity has very good liquidity. A high-yield bond may trade by appointment. So I could lose, let’s say, 10% having to sell the high-yield bond if it’s quoted, let’s say, 70 bid at 80 offered, if it’s perhaps a distressed bond or something like that, where my treasury bill is going to trade on a bid/offer of 1 basis point – or one hundredth of 1%. So even if I have 30 times leverage in that, we’re talking about 0.3% transactions cost on my invested capital versus transactions costs that may be 5 or 10% on the other investment. So again, a high degree of leverage is not necessarily more risky – it depends on what you’re levering.
It sounds like you’ve explained this before, who is it you have to convince of the value of leveraged instruments?
[Laughs] Well, I think what happens is that investors and the press and media in different forms tend to take a big red paint brush and say, “Ooh, leveraged strategies,” and paint an ‘X’ across it. And if you look within the hedge fund world this year to see what is the best-performing strategy, well, [some] of the best-performing strategies this year are what I would call traditional, fixed-income arbitrage strategies – government bond arbitrage strategies. Those strategies fell substantially out of favor post the credit crisis. Why? Because they use higher levels of leverage than the average strategy. Those strategies often use 5, 10, 20, in some cases 30-times leverage. But the reason they’re doing so well is because the opportunity set for the types of investment they pursue (basis trading, yield-curve trading, auction trades) is very rich right now because of the removal of proprietary capital and investors have been reluctant to enter those strategies, for fear that they’re using high degrees of leverage and [investors] don’t understand that in the application of the government bond markets, a high level of leverage is acceptable because there is the underlying market liquidity that supports it. So, leveraged strategies were all bad and now you’re starting to see that some leveraged strategies perform quite well in these environments and can operate efficiently on an orderly basis.
So, what is your advice to investors weighing the pros and cons of leverage?
I think my advice to investors would be two-fold: one, understand what it is that is being levered, if at all, in the investment strategy that you’re looking at. So when I understand what is being levered, it’s the volatility of what I’m levering and it’s the transactions costs associated with the instrument that I’m levering. And then, two, understand how that leverage is being provided. There are a variety of ways one can get leverage – one can get leverage in the futures markets, as we talked about, one can get leverage in a margin account, one can use the repo markets, one can use over-the-counter derivatives, one can finance through a prime brokerage account, one can use structured products, all of these have different implications.
Those providers of leverage that I would say are independent from the balance sheet of a bank – so examples of those would be futures or repo arrangements, where you don’t need a bank intermediary in the process – tend to be able to operate better in stressed areas when the banks tend to get concerned with their balance sheets. And those forms of leverage that are more bank-dependent – prime brokers, structured products, margin accounts, etc – tend to have greater risk in periods of market stress. Now, there are ways of mitigating those risks, but generally speaking, if you have an independent market that provides the leverage through some exchange vehicle or any commonly accepted money market instrument, that is better than having to rely on a single banker to be willing to lend to you on a continual basis.