Under the Epidemic: How Leveraged are U.S. Hedge Funds?

Risk assessment of U.S. financial investment institutions: hedge funds have the highest risk. 1. Structure of U.S. managed products: a market dominated by institutional investors, managed products are a vehicle for linking funds (residents, enterprises, government departments) and capital markets (stocks, bonds, currencies, etc.); the combined size of managed products is about $64.6 trillion, with pension funds, mutual funds, private equity funds (hedge funds), ETFs, and other asset products are 24, 17.6, 14.3, 4.4, 3.9 trillion USD respectively. 2. ETF leverage is not high: 193 of 1641 U.S. equity ETFs with leverage. 3. Hedge funds are potentially the most risky and contagious: hedge funds are 8.3 trillion USD in size, with high leverage, flexible and diverse, and complex trading strategies to the market "chase up and kill down".

Hedge funds are "leveraged" mechanism and measurement.1. There are two ways for hedge funds to obtain leverage. The first is financing, i.e., borrowing funds or securities from counterparties; the second is through derivative synthesis, i.e., indirect leverage obtained through the use of derivatives (e.g., options, futures, and swaps). Financial leverage (total assets/net assets) measures the first category of leverage, and total leverage (total notional exposure/net assets) measures the sum of the first and second categories of leverage. 2. Leverage of various types of hedge funds. Hedge funds include strategies such as equity, relative value, macro, event-driven, credit, and managed futures (CTA). The higher financial leverage is relative value, macro, and multi-strategy in order, with leverage of 6.0, 4.5, and 2.5 times in 2019Q2; the higher total leverage (excluding interest rate derivatives) is macro, relative value, and CTA in order, with 29.1, 24.0, and 19.9. 3. The main sources of financial leverage: repo market and prime brokers. The repo pledge rate is about 10% discount (pledges are mainly treasury bonds) and the prime brokerage pledge rate is about 70% discount (pledges are stocks and corporate bonds).

Hedge funds' own risks and risk contagion. 1. Hedge funds' own risks are due to "high leverage": high leverage magnifies losses and implies low tolerance for volatility; high leverage implies high sensitivity to "leverage costs", increased financing costs and sudden changes in initial margin requirements. High leverage implies high sensitivity to "leverage costs", higher financing costs and sudden changes in initial margin requirements. There is also liquidity risk and tail risk.2. Risks to the financial system from hedge fund risk. The first is the transmission to other financial institutions: the main counterparty of hedge funds is the prime broker, thus the risk is transmitted to other types of financial institutions. Second, the transmission to the capital market: a. Negative feedback loop. A negative feedback loop of market decline - position loss - selling assets for margin calls - tightening market liquidity - market continues to fall; b. The same model and strategy that will amplify volatility; c. The hedge fund crisis will affect the overall capital market liquidity.

Risk assessment of the current round of hedge funds I: systemic financial risk is less contagious. 1, financial leverage is significantly lower than in 07. Financial leverage (1.7 in 2019Q2) is lower than in the 07-08 financial crisis (2.6 in mid-2017). The Fed's timely endorsement of liquidity makes "stampede" deleveraging less likely. 2. Enhanced regulation and transparency of systemic risk for large hedge funds. The size of private equity funds, leverage, exposure, and linkages with counterparties are more transparent. Higher initial margin ratio (raised from 17% to about 30% after the financial crisis), limited bank exposure to hedge funds (e.g. Citi's on- and off-balance sheet credit to hedge funds, accounting for 4% and 1.4% of public credit and total assets, respectively), increased ratio of centralized clearing of OTC derivatives; reduced risk of concentrated redemption by investors.

Risk assessment of the current round of hedge funds II: Increased capital market volatility. 1. Elevated derivative leverage will increase price volatility and holder losses. Total hedge fund leverage is elevated (3.8 in 2019Q2 and 3.0 in early 2015), while financial leverage is down over the same period, the reason behind this is that hedge funds increase derivatives leverage; 2. Convergence of trading strategies will amplify market volatility: the pressure is greatest at the beginning of a high level decline. Risk parity strategy and all kinds of volatility targeting strategy convergence trading, in the market rush down, volatility jump, massive reduction in leverage, amplifying market volatility. 3, after a significant decline, the momentum of the future decline is weakened. If the market continues to fluctuate downward, lower leverage means less pressure on the market than before, and the negative feedback effect decays.

The current round of risk transmission mechanism. 1, this round is not a financial institution risk transmission. 08 subprime crisis is to the financial system as the "center of the circle" outward transmission; this round of market decline, the financial system itself risk is relatively small: large financial institutions are relatively robust, hedge funds risk contagion is not high. (For more details, see the report "Will there be a "Lehman" in the U.S. financial institutions this time? --(A comparative historical study) 2, the current round of risk transmission is through the "resident wealth effect". The high leverage of capital management products to residents, residents bear greater losses, through the impact of the "wealth effect" to the real economy, and ultimately affect the credit risk of financial institutions. 3, investors should pay more attention to the medium and long-term risks of the U.S. economy, the U.S. financial system of short-term risks are generally controllable.

Risk warning: market confidence continues to suffer; overseas economic downturn than expected; tail risks occur.

The financial leverage of hedge funds is declining and regulation is tightening, and the risk of contagion to the financial system is not high; the product leverage of hedge funds is increasing, thus increasing the volatility of the capital market, which will pass the risk through the "resident wealth effect". Investors should pay more attention to the medium and long-term risks of the U.S. economy, and the short-term risks of the U.S. financial system are generally controllable.