Credit Crunch Risk… Hedge Funds = Yes, Managed Futures = No

The SEC is out with a report bolstering/demonizing the reputation of hedge funds, with the somewhat shocking headline that the top hedge funds hold more than $1 Trillion in debt…  Whoa.. In case you were wondering that’s 1/16 of our nation’s total debt. (U.S. Deft Clock)

This is another instance where we like to brag a little. You Ready?  Managed Futures total debt = $0

Did we get a special report on Managed Futures funds debt?  No. Is it possible some managed futures funds have some debt. Yes. But managed futures as an asset class don’t need to borrow money in order to lever up returns the way hedge funds do. Futures contracts are specifically designed for vast exposure, with little required investment. (This is why you see disclaimers plastered everywhere across our blog, that futures have the potential for substantial loses.) There is an inherent leverage built into the futures contracts they trade. For instance, you can trade $1 Million worth of soybeans with just $200k in the account – no borrowing needed. That is because an initial margin deposit is set by the exchanges themselves, and it’s roughly equal to the amount of dollars that could be made or lost in a day, but usually only about 5% to 10% of the nominal value of the contract.

Hedge Fund Barrowing

So for example, with a soybeans contract good for 5,000 bushels worth of Soybeans, and the price $12.35 per bushel (down 14% in past 4 weeks and at a 17 month low, coincidentally), the nominal value of a single Soybeans contract is $61,750, but you only have to put up $4,590 in your account to trade that contract (CME margins can be found here).  That’s built in leverage of 13.45 to 1, meaning instead of borrowing $57,160 dollars, managed futures simply buy a futures contract.

Can’t hedge funds use futures too?  Yes, and they do – in a big way. But they aren’t exclusively futures. They trade in everything from shopping malls to junk bonds, to credit default swaps – which there aren’t exchange traded futures on, meaning they have to borrow to lever up those returns.

And this simple bit of math (1.47 trillion in assets, 1 trillion in debt) explains why hedge fund correlations move to 1 with stocks during a market crisis, and especially a market crisis brought on by tightening credit. When hedge funds have to borrow to hit their target return levels, and borrowing becomes more expensive – that hurts returns. When it is a sort of credit panic, with prime banks calling in lines of credit and requiring more capital to back borrowings – that leads to mass liquidations which pushes markets down further, which leads to more credit calls, and so on in a vicious cycle.

Managed futures, thankfully, don’t play this game – and indeed look to profit from such panics by riding the self-reinforcing sell off lower (a la 2008 past performance in not necessarily indicative to future results). The difference between hedge funds and managed futures on this front could not be more clear, and highlights how hedge funds are more of an alternative strategy than an alternative asset class. Hedge funds are tied to the same credit liquidity the general economy is, and can suffer from runs on the bank, so to speak. Managed Futures are not tied to credit liquidity, and can actually profit from such disruption.

Oh – and two other tidbits from the report really highlight the differences between managed futures and hedge funds relating to how liquid positions are and how quickly investors are allowed to cash out:

“15% of assets would take more than six months to liquidate

26% of capital would take more than a year to get back.”

Again, those numbers are 0% and 0% in the case of managed futures, with exchange traded futures contracts able to be liquidated in a day, and separately managed accounts able to be cashed out in 1-2 days depending on if (and how many) foreign futures positions are held.

You know our vote…

2 comments

  1. Two points-

    1/ credit default swaps are a poor example for your argument – they don’t require any borrowing. Nor do interest rate swaps, equity-linked swaps, and most other OTC derivatives. Idependent amount (akin to nitial margin) on these is typically negotiated at the time of trade and cannot be unilaterally varied by the banks, while the exchanges can vary margin on futures at will (a la gold in 2011).

    2/ you write as if the hedge fund would be on the wrong side of the trade and the managed futures on the right one. Yet managed futures funds can go into forced liquidations by variation margin calls and create a self-reinforcing cycle.

    This article doesn’t meet the good standard set by previous ones

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