War, inflation upping volatility and risk of leveraged positions going south

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Traditionally, family offices and high-net-worth investors (HNWIs) were concerned about preserving wealth to ensure it could be passed on to the next generation – as well as gifted to worthwhile causes. Certainly, it was nice to earn a good return but with their long-term horizons, many well-off families tended to be risk averse and content with moderate gains.

Most still have this focus. But a new kind of family office has emerged that is willing to take on more risk and use high leverage in pursuit of outsized gains and greater wealth.

Since family offices do not manage other people’s money, they can invest with even less regulatory restrictions and oversight than hedge funds. It’s not surprising, then, that many successful hedge-fund managers have decided in recent years to return clients’ money and rebrand as family offices that solely invest their billion-dollar fortunes. This is currently mainly an American phenomenon, and most Canadian family offices remain careful, with experienced investment teams.

One of the more famous hedge-find managers that converted was George Soros, who terminated his Quantum Endowment Fund in 2011. Another was Steven Cohen, who wound down his SAC Capital fund in 2013. Other hedge-fund managers joining this trend include: John Paulson, Leon Cooperman, Eric Mindich, Jonathon Jacobson, Melissa Ko, Clifton Robbins and John Thaler.

Nearly all are accustomed to using leverage, which can take many forms. Essentially, it involves buying stocks, bonds, futures and other securities on margin (a deposit) and borrowing the rest from banks, dealers or brokers’ margin accounts. Derivatives, like stock options, are also a form of leveraging.

Many hedge funds seek, as their name implies, hedged returns. They assemble portfolios with long and short positions in securities, and they arbitrage price discrepancies in various market segments such as convertible securities, merger bids and so on. While these hedged returns are usually more assured in bull and bear markets, they tend to be small – so hedge funds will often use leverage to give them a boost. Hedge funds also place leveraged directional bets on market trends, as well as market events. Whatever form leverage takes, the effect is to magnify returns. The downside is that it also magnifies losses.

Retail investors with margin accounts at brokerages are limited by investor protection rules to generally borrowing less than 50 per cent of the price to buy selected securities on stock exchanges – so they need to put up a margin of at least 50 per cent. Thus, they are restricted to amplifying their returns just two times: for example, if the price of a 50-per-cent margined security jumps by 10 per cent, the gain on the money deposited as margin is 20 per cent. (Margin requirements are different for preferred shares and some other stocks approved by regulators – 30 per cent, TSX Venture Exchange stocks – 75 per cent, and stocks priced $3 or less – 100 per cent).

However, family offices and hedge funds do not face such restrictions on leverage because they manage money for HNWIs, who are deemed sophisticated enough to invest without much help from investor protection regulations. If a security is bought at 25-per-cent margin and its price goes up 10 per cent, the gain on the deposited money is 40 per cent. A 10-per-cent margin delivers a 100-per-cent gain. But if the price drops -10 per cent, the losses will be -40 per cent and -100 per cent, respectively. For such declines, the broker will be issuing margin calls asking for more money. If the calls are not answered they will sell the security, turning the paper loss into a real loss.

Most of the former hedge-fund managers are sensible and knowledgeable risk takers but some less so, as demonstrated by the case of Bill Hwang. He set up his family office under the name of Archegos Capital Management and took billion-dollar positions in a handful of stocks though an esoteric financial instrument called swaps (where two parties exchange financial instruments or values, for instance brokerages buy securities and sell their returns for a fee to investors). One appeal of swaps is that they conceal the identity of the investor, which makes it easier for them to circumvent rules like the requirement to disclose acquisition of more than 10 per cent of a company’s shares.

Hwang was using thin margins granted at several brokerages to leverage his positions and when he got a margin call in late March of last year, he could not meet it. Brokers rushed to sell the stocks they were holding as backing for his swaps. Sales by the quickest of the group raised enough cash to cover their loans. But the onslaught of selling triggered a downward spiral in the prices of the stocks, and slower brokers had to unload at prices too low to cover their loans.

Their losses ended up in the billions of dollars. But luckily, they had large parent companies that were able to absorb the losses. Otherwise, there could have been a contagion effect, whereby a chain of defaults rippled through the financial system and threatened to undermine its stability.

Various regulatory agencies responded to the debacle by announcing they were launching investigations. But regulators tend to move slowly and, to date, not much of substance seems to be in place to serve as a check or safety net against another blow-up.

What makes it even more urgent is the increasing volatility seen lately in global markets due to rising geopolitical tensions between the three superpowers and the severe sanctions on commodities-rich Russia that are also affecting western markets. Adding to this is the need to tame out-of-control inflation with higher interest rates. The fear is that even sensible and knowledgeable risk takers with highly leveraged positions could encounter troubles dealing with such an environment. With billions of Western dollars trapped in the closed Russian stock market, and growing bans on imports of Russian oil and gas, if backers are not sufficiently capitalized, there could be ripple effects through global financial and economic systems.

While we all hope a global financial and economic meltdown is not triggered by volatile conditions and over-leveraged positions, perhaps its time to start thinking like Hetty Green, who became one of the wealthiest persons in the 19th century. She said she never bought on margin to have staying power when markets plunged. Despite her conservative approach, she turned US$6 million inherited in 1865 into more than US$100 million by 1916.

Larry MacDonald is a retired economist who writes at Investing Journey.