Hedge Funds Lever Up to Pre-Lehman Level as Banks Play Safe

As of the end of 2010, hedge funds have increased leverage to within 10 percent of pre-credit levels, according to a report from UBS Prime Brokerage Services and have likely increased risk up even more to start this year, traders said.

Gross leverage for funds has climbed 43 percent from the bottom reached after the collapse of Lehman Brothers in 2008 and is up 13 percent in 2010, according to UBS. Risk-taking surged in the second half of the year as hedge funds scrambled to avoid the fate of another year of underperforming the S&P 500 and as the Federal Reserve signaled it was ready to flood the market with more liquidity through its second round of quantitative easing.

“My guess is that at this juncture we are close to peak leverage,” said Stephen Weiss, co-founder of Short Hills Capital who also worked for S.A.C. Capital at one time. “It’s a function of investors in hedge funds being more comfortable with risk at this juncture. This is evident in the ability of hedge funds to raise additional assets. Additionally, everyone wants to make more money and the quickest way to do that is through leverage.”

Meanwhile, in the latest example of banks shedding riskier trading units, Morgan Stanley yesterday reached an agreement with its proprietary-trading chief Peter Muller for him to spin-off and form a new firm in 2012. Large banks must get rid of their proprietary trading units, which most resemble hedge funds, in order to comply with the Volcker rule contained in the Dodd-Frank financial overhaul.

Jan Mammey | Stock4B | Getty Images

Gross leverage is back to nearly 2-to-1 for U.S. funds, compared to the sub 1.5 leverage ratio seen at the bottom, according to UBS data. Keep in mind that this is the average across the board, so many funds could be back to the high-flying days of 20-to-1 and greater.

The increased leverage, along with the formation of new funds by former traders at banks, will spur hedge fund assets to leapfrog past pre-Lehman levels and further enlarge the industry’s prominence on Wall Street and tighten its grip on daily trading in markets.

Oddly, hedge funds are garnering more assets even after their performance trailed the market again last year. Returns averaged just 10.5 percent, according to UBS, compared to a 13 percent return for the S&P 500 in 2010. To be sure, some very bad performing hedge funds skew this average and investors figure that with leverage back and a more stable world, hedge funds are once again the best place to get the best return, even net their lofty fees.

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“The hedge fund industry growth will accelerate with assets setting a new peak by the end of 2011, passing the $2 trillion mark,” stated UBS. Funds focused on macro themes have already recouped their assets lost during the financial crisis, while funds focused on stock picking still have a ways to go, according to the report.

“Macro still king as long as quantitative easing No. 3 is a possibility, so I would assume that macro will have another good asset gathering year in 2011,” said Nicholas Colas, chief market strategist at BNY ConvergEx. Meanwhile, a high correlation between individuals stocks has hurt long/short funds, according to Colas.

While it may be good for market momentum in the near term that hedge funds are increasing their firing power and that the higher leverage is no longer contained in banks systematically important to the financial system, it doesn’t necessarily mean the bull market is here to stay. This pre-Lehman leverage could add fuel to any correction or bear market that may come about because of the many risks that still lie ahead.

“I've seen funds moving up their volumes to make up for the smaller opportunities presented” in this low volatility environment, said Jon Najarian, co-founder of TradeMonster and a ‘Fast Money’ trader. “When the market moves, which we all believe it will eventually, those new to the increased size of their book may find the leverage can cut both ways.”

* For the best market insight, catch 'Fast Money' each night at 5pm ET, and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC.

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