AIMA/CAIA Study: Adding Leverage Does Not Necessarily Increase Performance Risk

Oct 25 2016 | 9:46pm ET

Adding leverage to an alternative investment fund does not necessarily increase the risk, according to a joint study by the Alternative Investment Management Association and the CAIA Association.

Although counter-intuitive at first glance, the research paper, third in a series about hedge funds, suggests no direct relationship exists between hedge fund leverage and volatility and downside risk of fund performance.

For example, the study found that despite typically having the highest leverage ratios of all hedge fund strategies, relative value or arbitrage strategies have lower volatility, on average, and have suffered smaller losses during periods of market stress over the last 20 years. Equally, funds that typically employ lower leverage, such as long/short equity funds, have experienced marginally higher volatility and drawdowns since 1996.

The authors of the study, AIMA CEO Jack Inglis and CAIA Association CEO William Kelly, said this suggested that a fund’s risk profile is influenced more by the nature of the underlying investments than the use of leverage alone.

“A common misunderstanding is that a levered asset is always riskier than an unlevered asset, even if the levered asset has low risk and the unlevered asset is highly risky,” the report states. “The picture becomes even more complex when we start to look at portfolio of assets where leverage can be used in parts of the portfolio to offset some of the exposures magnified by the use of leverage in other parts, resulting in an overall risk reduction or transformation.”

A fund that is levered four times its size, for example, is not necessarily twice as risky as one that is levered twice its size, the report explains. Fund managers are increasingly tailoring the use of the different forms of leverage to target precise risk and return objectives.

“Understanding the impact that leverage can have on a portfolio is essential for pension funds and other investors,” said AIMA’s Inglis. “Leverage and risk are not the same thing. Most hedge funds use a modest amount of leverage – but as our study shows, even those with higher leverage levels are not inherently more risky than, say, investing directly in equities, commodities or other traditional asset classes.”  

The report, named “Made to Measure - Understanding the Use of Leverage in Alternative Investment Funds” is the third in a series of educational papers about hedge funds for pension fund trustees and other fiduciaries by AIMA and the CAIA Association. The previous studies focused on allocator issues (“The Way Ahead”) and hedge fund strategies (“Portfolio Transformers”) and are available on AIMA's website. The next paper, due to be published in 2017, will focus on liquidity.

AIMA is a global alternative investment industry association with 1,700+ corporate members in more than 50 countries. It is the co-founder of the well-known Chartered Alternative Investment Analyst designation, and its manager members collectively manage more than $1.5 trillion in assets worldwide. 

Founded in 2002, the CAIA Association is best known for the CAIA Charter, an internationally recognized credential granted to those in the institutional alternative investments industry upon successful completion of a rigorous two-level exam series and accumulation of relevant work experience. 

The association is comprised of more than 8,400 alternative investment professionals located in more than 90 countries, sponsors more than 140 educational and networking events per year and has 37 academic partnerships with leading universities around the world.

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