Fund of Funds Investing: A Roadmap to Portfolio Diversification

Chapter 10. Leverage Facilities and Risk Management

Until the beginning of the 2007 liquidity crash, leverage was the friend of the hedge fund community. It also was a friend of the fund of funds industry, specifically those that were able to use leverage to "juice" returns. By adding leverage of 1x, 2x, or 3x to a "conservative" portfolio of hedge funds that had low volatility and low correlation to the public markets, hedge fund returns could be increased by hundreds of basis points. The cost was seen as nothing more than the spread between the price of the loan and the return achieved. Simply put, money was cheap, returns were high, and leverage was good.

LEVERAGE AND PRIME BROKERS

While several large investment banks—whose clients were prime brokerage clients—were big providers of leverage. Many commercial banks provided the same sort of leverage facilities to managers and welcomed the money with open arms. Many of the banks providing credit were banks that were not based in the United States, but several U.S. money center banks such as JP Morgan Chase, Bank of America, and Citibank, and international banks such as Banque Nationale de Paris and Société Générale SA, also created a niche to finance the leverage transactions. The reasons were the same for all the banks as it was for the managers: money was cheap, and the returns were high and consistent. Simply put, loaning money to hedge funds and fund of funds was a profitable business.

The transactions, while sophisticated on paper, ...