Embedded leverage and performance of hedge fund share classes
1University of Oulu, Oulu Business School, Department of Finance, Finance
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Oulu : J. Väisänen,
Some investors may not be able to use leverage at all or they face different margin requirements. Investing in securities with high-embedded leverage enables those investors to obtain desired level of market exposure without violating their margin constraints. Investors in hedge funds can gain access to this high-embedded leverage by investing in hedge fund share classes that have leverage multipliers higher than one.
Hedge funds characteristically exploit different arbitrage and speculative investment strategies. These strategies typically entail illiquid assets, and to obtain the flexibility hedge funds often restrict investors’ ability for capital redemptions. This is done by applying different share restrictions. Illiquid investments can also yield to serially correlated returns.
This study employs extensive hedge fund database, which is constructed by merging five individual databases. The use of this database contributes to previous academic studies, since such thorough database has not been employed in studies concerning hedge funds. Furthermore, this study contributes to the recent academic studies by investigating the return differences between unleveraged and leveraged hedge fund share classes. Additionally, this study considers, whether the return spread is larger for hedge funds that invest in illiquid assets. Finally, this study investigates whether some predefined macroeconomic and risk factors are able to explain those returns differences.
This study finds two specific implications that contribute to the previous academic literature. First, there exists a return difference between unleveraged and leveraged share classes, and that difference is statistically and economically significant. Second, return difference can be partly explained by some macroeconomic and risk variables. Aggregate hedge fund flow has a positive relationship with the return difference and it acts as a key variable in explaining those return differences.
Additionally, this study finds that overall movements in financial markets affect the returns of leveraged hedge fund share classes. Increases in different risk variables cause leveraged share classes to reduce their exposures and their leverage is not constantly at the promised level. This makes them to resemble more their unleveraged pairs and induces return difference to decrease.
As a conclusion, returns of leveraged share classes, scaled with their respective leverage, are lower than the returns of unleveraged share classes. This finding brings important implications for hedge fund investors. Ability of some macro and risk variables to explain the return difference helps investors to understand the factors affecting the return spread and help them to time leveraged hedge fund investments properly.
© Jesse Väisänen, 2013. This publication is copyrighted. You may download, display and print it for your own personal use. Commercial use is prohibited.