07/27/2011

Citadel Puts Equity Managers on Short Leash

Citadel has taken steps to rein in its equity portfolio managers by limiting the amount of risk they can take.

In recent weeks, the Chicago hedge fund operator has adopted a policy requiring all equity books to be “beta neutral” at the end of each day. A portfolio that’s beta neutral has little or no sensitivity to market volatility. As a practical matter, the requirement means a portfolio’s long and short positions have to balance out.

Why the change? Sources said it could be a sign that Ken Griffin’s firm is getting ready to boost leverage across its equity business in an effort to juice returns and lift its main funds back above their high-water marks. Citadel’s flagship Kensington and Wellington vehicles each fell 55% in 2008 and have been struggling to make up for the losses ever since.

As a result, the firm has gone for nearly three years without any performance-fee revenue from those funds. Meanwhile, management-fee revenue has fallen sharply since the market crash, as assets under management have dropped to $11 billion, from about $20 billion in 2007.

One reason for the outsized 2008 losses was that Kensington and Wellington were heavily leveraged, perhaps as much as eight times. One source said Citadel recently raised the leverage limit for equity investments, though the firm denied it. A Citadel spokesman said the leverage on its equity books has held steady for the past few years at about six times.

Even six-times leveraged, however, is significantly higher than average for equity managers. Andrew Ang, a Columbia University professor who co-authored a 2010 study titled “Hedge Fund Leverage,” said the equity managers he’s examined employ 1.3-1.6 times leverage, on average.

“When you get too far under water, you have two options,” Ang said. “One is to close the firm. The other is to swing for the fences, do the Hail Mary pass and use lots of leverage. If it does well, you get above water and rake in good fees.”

Since the financial crisis, hedge funds have generally dialed back leverage. But a May report by Hedge Fund Research found larger fund operators have been quicker to employ leverage than smaller firms. About 25% of managers with more than $1 billion of assets are now using leverage ranging from two to five times, according to the report.

Citadel’s returns have been well above average this year, with its flagship funds up 11% each. Industrywide, the average hedge fund return during the first half was less than 1%, according to the HFRI Fund Weighted Composite Index.

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