Who wins with leverage?

Leverage increases apparent returns in best of times but Increases risk considerably in worst of times. Investors do not benefit from leverage over time. Managers benefit greatly from leverage. Derivatives are highly levered. Traders think that it is silly to spend any time thinking about notional amounts of derivatives. Insurers should learn that they need to pay attention to the notional amount of their insurance contracts. Owners of now highly diluted shares of banks (and AIG) now know that the leverage of those organizations did not in the end create value. Insurers, like banks, are by their fundamental nature highly leveraged with capital a tiny fraction of gross obligations. Insurers should take extreme caution when considering activity that increases leverage. And they should make an analysis of the true amount of leverage in their activities an important activity before entering a new activity and periodically as the world turns.

For example, if one investor puts his money in a 2/20 hedge fund that is 10 for 1 levered and that pays 10% interest on its funds. If the returns for the first four years are 20% per year, After 4 years, the investor is up over 400%! The hedge fund manager has been paid over 150% of the original investment and the debtholder has been paid 400%. But then in year 5, the investment loses 20%, giving back just one of those four years of outsized gains. All of a sudden, the investor is down to an 8% cumulative gain!!! while the manager and lender have slightly higher gains than after the four fat years.

The sister of this investor had the same amount of money to invest, but put it into an unlevered fund with the same types of investments and without the 20% profit share for the manager. After four fat years of 10% gains, the sister is up over 35% and the manager has been paid only 7% of the original fund value. Now the market drop hits sis’ fund with a 10% loss and she ends the five years up a respectable 19%. The fund manager gets about 9% of the original fund for his five years of work.

Leverage Illustration

Of course, the illustration can be manipulated to make anyone the supreme winner. But this scenario seems pretty telling. Leverage primarily benefits the fund manager, not the investor in this scenario. In many scenarios they both benefit, but there are no scenarios where the manager does poorly on a leveraged investment fund.

So when you die, pray to come back as a leveraged hedge fund manager.

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Tags: Enterprise Risk Management

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