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This article was authored by Shahriar Shahida, Chief Investment Officer at Constellation Capital Management LLC, New York.
The pathology of almost every failed entity reveals one dominant culprit: excessive leverage. Contrary to popular perception, the quality of assets held by the entity is almost a secondary factor in its demise. A portfolio of perfectly safe US government debt levered too much could be more toxic than buying a pool of defaulted assets without any leverage. What’s more, the vulnerability of entities relying on excessive leverage is not limited to directional strategies.
As was demonstrated by the demise of LTCM, even market neutral strategies that rely on excessive leverage are vulnerable to sudden market dislocations. This is due to the fact that during times of stress, market participants sell whatever they can, and in the process, turn all market neutral strategies into directional ones.
As the basis between liquid and illiquid assets widens out, investors are forced out of trades at whatever the clearing price of the illiquid assets may be.
None of these facts should be a surprise to anyone who witnessed the spectacular collapses of the past decade. Yet time and again, markets find themselves victims of the overindulgence of these leveraged players.
What is interesting though is that over the past decade, risk managers and regulators were almost obsessively focused on the hedge fund community. Some would argue that...................... To view our full article Click here
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