Leveraged Investments
Hi
I'm looking at two leveraged investments and I don't quite fully understand them. I understand the underlying but I don't understand how the leverage works on these investments.
Let me give you some background.
There are two investments. The first has 200% exposure (1) and the other has 400% exposure (2). The investments invest in an index of hedge fund managers. What I do understand is that given the amount of leverage the returns on investment (2) will be greater than on investment (1) because of the leverage used. I also understand that the losses incurred could also potentially be greater.
Both products are being produced by a global IB on one of their platforms. What I do not understand is the mechanics behind the returns. As expected, investment (2) with its 400% exposure has returned roughly double of investment (1) as they are both investing in the same hedge fund managers.
Now, I'm assuming the global IB is providing the leverage and the increased exposure. What I do not understand is why they are providing the leverage and how they are making money out of these products. Surely, in this scenario where these products are making money (the 400% exposure investment is annualizing around 28% return) then someone has to be losing money.
These hedge fund managers are trading on margin. If my $100,000 investment is giving me $400,000 exposure then who is losing out in this transaction? Obviously I am benefiting but who is losing? I the investment loses money and therefore my losses are 4x greater, then who gains?
I hope this is easy for you guys to understand. As you can see I'm a little lost and any help would be greatly appreciated.
They produced them/providing the leverage so that schmucks will trade on them so they can make money on the trading fees.
Thanks - the investments have maturities of 6 and 10 years.
Are you saying their producing these products so that they make money from the buy / sell spread they get if investors want to cash up their investments before maturity?
analogous to a leveraged etf (probably can't redeem for underlying). so you buy in at current price level. Then a 1% change in the value of the funds (which are likely levered themselves) would give you a 2%/4% change in the value of your shares less the effective interest rate on the debt (might be taking this via load/fees/other mechanisms).
The theory here is that hedge funds optimize leverage on their own portfolio, a diversified fund of funds can reduce volatility and thus you can lever more. this is very difficult to do in practice and even if you get the math right future changes in correlation of fund returns can still fuck you. it looks like the IB is dealing with cash flow/liquidity issues (or these are income producing funds investing in levered loans, real estate, CLOs, CMOs and the like).
looks like the IB is giving you limited liability in return for the fees.
Here's the transaction flow from what you've described:
1) You deposit $1mm with Global Bank 2) Global Bank loans you an additional $1/$3mm depending on the product 3) Your $2mm/$4mm is invested with the index of managers who in turn invest in the markets 4) Your capital returns the performance of the index less borrowing costs but your equity's returns are more levered because of the impact of the borrowed money
This is attractive to different parties for different reasons: 1) You: Get levered returns (whether this is a good decision or not is another issue, but this is the reason you find the idea attractive)
2) The Bank: Generate interest income from the leverage they provide to you, build relationships with the funds in the index that drives trading fees etc [this is what Seabird meant. If I am a banker and I help place $100mm in AUM with a hedge fund, they will be appreciative and use my prime brokerage for their trades etc.] and with you, the investor, to generate future asset management business.
Depending on the interest rate they charge, the lending could actually be pretty attractive on an LTV basis (ie 50% of account value in product 1 and 75% in product 2).
It's also likely that they're charging management fees or placement fees in addition to the interest expense. Read the footnotes.
3) The managers: Increase AUM.
It's also possible that they're doing this on a synthetic basis for one reason or another (basically a total return swap where no cash investment in the managers is made) but that seems unlikely. That is also the difference between this and a levered ETF (this is a levered cash investment whereas a levered ETFs are unlevered investments in synthetic securities with leveraged exposure).
So the OP told me that it is in fact synthetic exposure to the underlying index. Therefore the mechanics are, like MonkeyC said, like a leveraged ETF. However, depending on the index there may not be a market for the kinds of options (usually forwards, futures, and swaps) that are used to created levered exposure by an ETF.
The bank may be writing a custom derivative themselves, so they're taking on the other leg of the trade (ie they will charge interest on the initial amount of leverage provided and will pay out the increase in the index if any). The reasons they'd do this are the similar to a cash transaction (they take fees/charge interest and have the cushion of your equity if the index declines).
It may be they're offering this product to hedge their own exposure or their other clients' exposure to the funds in the index.
Thanks Kenny. That helps a lot.
Just one other things, and bearing in mind that I'm new to this and I can't find too much info online, how do the mechanics of the bank writing this derivative work?
The index has been positive every year for seven years so is the bank losing money on this transaction? Are they happy to lose money so that they can investors on their platform and charge the fees for this?
Is there any way you could describe the process of writing the derivative and how this works?
Thanks.
Well the "mechanics" of writing a derivative aren't really that complicated-it's a contract between you and the counterparty that specifies who pays what when and what the benchmark is.
Without a lot more information on the product it's not really practical to get into more detail than that.
The bank would cover their position, and lock in the spread so they are not losing money regardless if the market moves up or down, unless of course they feel strongly about it one way or another and decide to leave it unhedged.
The challenge here is that (assuming it's as-described by the original poster) it's a custom product based on a hedge fund index, not something with an active options market, so they can't lock in the spread unless they're selling the opposite version of this product to someone.
It's possible that they (either directly or on behalf of an asset management client, fund of funds, etc) has exposure to the index or a similar basket of hedge funds and are using this product to take off some of that risk (plus earn fees and interest).
Kenny_Powers_CFA... great posts... I've never seen this concept explained so concisely. +SB
Agree with Relinquis that Kenny's posts are awesome.
I might be able to add a little bit on how you generally hedge weird things (without asserting this is actually all that weird). Without knowing the details of the product, the way you typically hedge a custom index like this is statistical and\or utilizes cross market hedges. These don't work so well, so highly customized derivatives without a liquid underlying will tend to be very expensive in some sense.
An example of a non-retail market where "weird' hedging is normal is energy spread options (ex. heat rate options). To be honest, most high-ish margin exotics are very hard to effectively hedge. Things with constant delta are a little easier.
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