Pretty self explanatory title, but if your average pod unlevered return is 3-5% and traditionally they’ve put 5x leverage on that at 0-2% interest rates, how are pods going to make money if fed fund rates persist at 3-5% and you can’t arb any of the leverage benefit? Seems like pods are getting insane inflows right now so am I not thinking about this correctly?
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Yeah but that pure alpha on a beta neutral book isn't going to scale with the fed funds rate. Why would an investor pay for "pure alpha" of 3-5% that has huge fees + downside risk if that same investor can make 3% - 5% in rolling 3 month treasuries. Doesn't make sense to me.
Treasuries are still beta. It’s beta to the Treasury market. Global investors are not limited to investing in just US markets or in the U.S. they might not even live in the US. Now that you write that, it’s possible these funds just find cheaper leverage outside of the US. There was a time when rates in Germany were negative. My guess is Japanese rates may still be close to 0. They can just borrow in yen to lever up their returns.
With rates at these levels, prime brokers pay HFs a rebate (currently around 3%) on most short positions. So you pay say 4% on leverage to fund your longs, earn 3% on shorts. That 1% spread remains constant whether fed funds is zero or 10%.
Thanks. Helpful information to know. I appreciate you sharing that. Good luck and best wishes
Makes sense TY
And it’s more like 55-60 bps if you’re at a large shop.
not to mention, you’re talking pm economics. Firm level is different. There are tons of offsetting positions at the biggest pod shops, so they earn the financing spread on those rather than paying it to the banks.
Thanks for bringing this up, spot on. For those interested, here's a good article with a more in depth explanation.
https://www.sandhillglobaladvisors.com/blog/the-short-rebate-what-is-it…
Ill paste a comment I had below on this from an earlier thread:
This is something that I had a hard time understanding for a while but clicked all of a sudden. When you are quoting a rate, think about what exactly that means. In this case, lets assume you are talking about the fed funds rate. That is the cost a riskless counter-party has to pay to borrow money. When we want to lever a stock portfolio or get into a short position, we arn't borrowing money, we're borrowing stock, and consequently this different thing we are borrowing has a whole different rate curve to it.
Rates for locates / stock loans for leverage are much lower than $ rates most of the time, simply because there is a TON of inventory in massive co's with very long term horizons. So for example lets say you're a MM PM running a book levered 5x - you can get that exposure for cheap because some mega asset gatherer who knows they want to hold most of their holding in huge size indefinitely (so they dont care about short term moves / dont need their inventory anytime soon) can loan out these holdings to scrape a few extra pennies in interest - this is what a securities lending desk at a bank facilitates. Rough explanation / I'm sure this fails when looked at too much, but this is my rough understanding.
It doesn’t actually have a different curve to it.
it’s simply SOFR less the borrow fee. Most borrows are GC which means 25bps but HTB stocks can be significantly higher. So you earn a rebate of SOFR less that fee.
Your post vaguely suggests leverage works the same way. It doesn’t.
Ah - thanks for the correction. Did not see it from that angle.
Say I’m a newly seeded HF that is given $100m wire from LP right into my IBKR brokerage account, and my mandate is to go long/short stocks. I initially use that $100mm cash to buy ten equal weighted long stock positions and now have zero dollars and $100mm worth of stocks sitting in IBKR.
what is the economics / can someone walk me through what happens when I want to short stocks to bring my current exposure of 100 gross / 100 net to 200 gross / 0 net (i.e. 100% long 10 stocks & equally short $100mm of stocks). I want to understand how much collateral (and where it comes from?) is put up as % of the $100mm short exposure I'm looking to take on, what % interest you earn on that (= short rebate?) vs. borrowing costs, dividend costs (on average?), and what else may be going on with my cash that shows up in my imaginary IBKR account.
It’s a little weird to try to discuss it in sequence because it gets a bit complex (because you’re initially over collateralized and then it declines as you add shorts). So let’s look a different way.
Let’s just look at the final state of the world. Your PB (in this case IBKR) determines how much margin you need. Let’s pretend it’s $60mm initial margin on the entire $100mm long and $100mm short book. And let’s pretend you choose not to post more than initial margin.
You post $60mm. Borrow $40mm at SOFR + 30 bps to fund the longs. On the short side, you have received $100mm of cash for the shorts. You earn SOFR less your borrow cost on that (which is 25bps if the stocks are GC or higher if they are HTB). You also have to pay out any dividends on your shorts on top of your borrow cost.
Now if you want to complicate it, let’s assume uou post an incremental $10mm. It reduces your leverage. So instead of borrowing $40mm at SOFR + 30, you’re borrowing $30mm.
And depending on your portfolio gains/losses you can end up with incremental deployable capital or margin calls.
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