What do home-owners and hedge funds have in common?

What do home-owners and hedge funds have in common?  Both are making leveraged bets on the value of an underlying asset.  A home-owner typically buys a house with 20% down, borrowing the remaining 80% of the purchase price from a bank.  Ignoring the cost of selling (which can be as high as 7% of the purchase price), if the house appreciates 20%, the homeowner’s equity has doubled.  For example, a house is bought for $100K with a $20K down payment and $80K mortgage.  If the house appreciates 20%, it’s now worth $120K.  The mortgage is still $80K, which leaves the home-owner with $40k in equity, or a double of their initial investment.  If the house should fall 20% in value, however, and be worth only $80K, then the home-owners equity is wiped out and they have a 100% loss.  If the house had been purchased with 100% cash, the loss would have been limited to 20%.

Hedge funds come in many flavors and strategies, but the key distinction between hedge funds and traditional investment firms such as ours is the element of leverage.  A hedge fund can borrow funds to increase returns, but this borrowing leaves the hedge fund vulnerable to substantial losses.  For example, a hedge fund buys $100K of stock with $50K of a client’s money and $50K borrowed from their prime broker.  If the value of the stock portfolio goes up 50%, the client has a 100% gain (portfolio worth $150K, less the $50K loan, leaves $100K in equity, or a double.)  If the value of the stock portfolio falls 50%, then the client is wiped out.  Returns increase faster the higher the percentage of borrowing.  For example, if a client could buy stocks with 5% down and 95% borrowed, they could double their investment with just a 5% rise in the value of the stocks.  However, a mere 5% drop would wipe them out.  So retail brokerages generally limit the initial maximum loan (margin) to 50% and the maintenance margin to 70% (i.e. if the value of the stock portfolio falls to the point, about $71,500, where the loan equals 70% of the value of the portfolio, then either the client has to put up more cash or the brokerage will sell their stocks.)  At HCMI, we never use margin because we never want to be in the position of having to sell stocks whether we want to or not.

In recent years, hedge funds have made substantial investments in strategies which can be loosely called “credit spreads.”  The low risk rate on the 10 year treasury is currently 4.76%, and you can readily “borrow” at that rate by selling treasuries short (let’s say you sell short $1 million in the 10 year, for which the maintenance requirement is 98%, not 70% as in retail equity accounts.)  You would get $980,000 to play with, as long as you covered $23,800 in coupon interest every 6 months.)  If you invested that cash in a corporate bond yielding 6.5%, you would get a coupon of $31,850 every six months ($980K *0.065/2), on which you’d capture a gain of $8,050, or $16,100/year.  Since your equity is the $20K maintenance requirement on the Treasury bond, your annual return approaches 81%!